GLOBAL PERSPECTIVES OF REGULATORY REFORM FOR SHADOW BANKING: IMPACT ON THEIR BUSINESS MODELS

S a mu e l G e o r ge

T h i s e s s a y w a s o r i g i n a l l y s u b m i t t e d f o r t h e d e g re e o f M a s t e r o f L a w s o f B r u n e l U n i v e rs i t y , L o n d o n . F u r t h e r mo d i f i c a t i o n s h a v e b e e n ma d e t o t h e o ri g i n a l v e rs i o n . O ri g i n a l l y s u b mi t t e d i n Se p t e m b e r, 2 0 1 1

C o nt a ct : c a s a m my @ g ma i l . c o m M o b : + 4 4 7 4 4 87 9 6 2 80

INDEX Abstract Acknowledgement Introduction Framework of Regulatory Objectives ii iii 1-2 3-18

1.1 Principles of financial intermediation............3 1.2 Traditional Banking vs. Shadow banking system..5 1.3 Credit Intermediation theory Maturity transformation; Credit transformation; and Liquidity transformation.7 1.4 Structural reforms in the financial sector.12 1.5 Moral hazard, Conflicts of Interests and Gatekeepers duties..14 1.6 The law and finance view: the need for financial regulation...16 1.7 Concluding remarks ... 18 Business model perspective of Shadow banking system 19-25

2.1 The business model perspective ...19 2.2 Systemically Important Financial Institutions (SIFIs)...21 2.3 Systemically Important Financial Markets (SIFMs).23 2.4 Concluding remarks..25 Regulatory reforms: Macro perspectives 3.1 Part I Institution-based regulations 3.1.1 Volcker Rule.26 3.1.2 SIFIs & Orderly Resolution Regime.....29 3.1.3 Capital adequacy regime affecting investment firms ...32 3.2 PART II: Market based regulations 3.2.1 SIFMs - Market Infrastructure and behavioural reforms...34 3.3 PART III: Broad basing regulatory boundaries 3.3.1 Information Asymmetry mitigating factor to weaknesses in market infrastructure...38 26-41

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3.3.2 Secondary market participants like Hedge funds & Private Equity38 3.3.3 Corporate governance rules39 3.4 Concluding remarks...40 Motivations for Shadow Banking Financing Structures 42-53

4.1 Bankruptcy remoteness & insolvency remoteness in financing structures42 4.2 Cross border tax structuring.47 4.3 Applicable law or Governing law48 4.4 Liabilities: Fiduciary liability; Tort law; Conflict of Interest; and Risky decision takers liabilities .50 4.5 Concluding remarks.53 Regulatory Alternatives 54-59

5.1 Financial System: Market economy and Business Models 54 5.2 Self-Regulation vs. Regulatory Intervention...55 5.3 Functional Regulation vs. Institutional Charter..56 5.4 Regulatory Borders and Regulatory Co-operation..57 5.5 Concluding remarks.59 Concluding remarks for the dissertation Appendix List of Abbreviations List of Cases and Statutes Bibliography 60-61 62-63 64-66 66-71

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Abstract Post the financial crisis of 2007-09, global forums like the Financial Stability Board and national regulators have deliberated on regulatory measures for shadow banking. Their perspective of regulatory outcome, is to reduce systemic risk and prevent firms from being too-big-to-fail. As deliberations are still underway, this dissertation examines the issue of regulation from two perspectives: (i) business models of shadow banks; and, (ii) functional regulation as a regulatory alternative to institution-based regulation. Shadow banking participants are majorly nimble-footed financial intermediaries, who can organise themselves and their financial offerings, to arbitrage regulatory requirements, even across different jurisdictions. They are alternate credit providers and primarily involved in maturity transformation. Shadow-banking model for financial intermediation not always supports economic-value-added (EVA) objective, hence regulatory objectives need to look at the business models of these intermediaries, to arrive at proper regulatory trajectory. The dissertation reviews and compares regulatory reforms across US, UK and EU, and attempts to analyse various shadow banking financing structures and how they are impacted by regulatory reforms. The dissertation suggests that S ystemicall y Important Financial Markets (SIFMs), based on functional regulation may be better regulatory targets than Systematically Important Financial Institutions (SIFIs), or institution-based regulation.

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Acknowledgements I am really grateful and appreciative of this opportunity to undergo the Masters degree program at Brunel Law School. It has broadened my mind and cognitive capabilities to analyse and reflect on issues affecting global financing. It also helped me discover a new area of interest namely financial regulation which has undergone the wide ranging changes post-financial crisis. I specially would like to thank Dr. Muhammed Korotana, who kindly agreed to guide me for this dissertation. I am also thankful for his lectures which helped me discover this new interest area of financial regulation which hopefully will redefine the conduct of business financing. I also thank the professors and staff of Brunel Law School, which made this learning experience truly enriching.

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Introduction The years preceding the financial crisis of 2007-09, the impetus for constant financial de-regulation underpinned the belief in efficient market hypothesis. The hypothesis believed that an invisible hand corrects distortions created by self-interested market participants, eventually achieving market efficiency. The colossal distortions caused by the financial crisis abandoned any remaining loyalty to this theory, causing regulators all around the world to come together to tame financial markets and their participants. On the onset of the crisis in 2007 a culprit was hauled out of the shadows, with no detailed description other than being commonly referred to as shadow banking system. It included entities actively involved in bank-like-credit-creation without the same kind of regulatory oversight for its banking counterparts. The shadow banking system is widely fragmented, comprising of participants like global financial conglomerates on one end and niche private funds like private equity funds/ hedge funds on the other end. Some of these conglomerates had public-insured-depositorybanks and insurance firms under their common control, making them eligible for Government support, at the same time not being subject to bank-like regulations. A quick fix that emerged thence was to tame these financial giants, labelling them as systemically important financial institutions (SIFIs) which are considered too-big-tofail. The regulatory emphasis has been too overweight on SIFIs without giving too much importance to the systemically important financial markets (SIFMs) they operated in. The theories of financial intermediation have long since been attempting to define the economic value added (EVA) of business models of financial intermediaries in the credit creation function. It is the economic rationale behind their business models which truly defines the vagaries of the shadow banking participants. Institutions are easily

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substitutable or interchangeable, whereas the sustainability of their function needs to be the parameter on which EVA is to be measured. The underpinning discussion of this dissertation is an attempt to identify underlying objectives of regulatory reforms, in the US, UK& EU regulatory regimes. The scope of this dissertation is limited to credit intermediation function within the shadow banking system, while acknowledging that certain market-making activities impact credit creation. The approach & methodology for this dissertation was to create a framework of regulatory objectives for financial intermediation activity of shadow banks and explain the impacts of recent regulatory reforms on business model of shadow banking participants. The rhetoric used is a narrative reviewing, comparing and contrasting reforms across US, UK and EU, whilst identifying underlying regulatory objectives. The discussion finally considers regulatory alternatives like: self-regulation vs. regulatory intervention; functional perspective vs. institutional charter; and border parameters for regulators. The literature relied on for this dissertation includes, legal analysis and relevant economic literature. The discussion is divided into five chapters: Chapter 1- sets out a framework of regulatory objectives based on principles of financial intermediation and credit intermediation; Chapter 2 elaborates business model perspective of the shadow banking system; Chapter 3 focussed on direct / indirect effect of reforms: institutionbased, market-based, and reforms aimed at broad basing the regulatory net; Chapter 4 assesses factors mirroring the motivation of financing structures/deals by the shadow banking; and finally, Chapter 5- while explaining alternatives concludes on the most appropriate regulatory outlook for shadow banking activities. The dissertation then concludes, summarising the findings under the aforesaid chapters.

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Chapter 1 Framework of Regulatory Objectives Shadow banks are necessarily financial intermediaries for credit creation and their EVA function has been discussed based on theories & principles governing financial intermediation and credit intermediation. Shadow banking and traditional banking are further distinguished in the context of bank-based and market-based systems. Finally certain reform proposals and their justification have been discussed stressing the importance of financial regulation. The findings form the framework for regulatory objectives. 1.1 of Financial Intermediation The early theories of financial intermediation suggested the role of financial intermediaries as a means to reduce transaction costs and bridge information asymmetry between savers and investors.1 Transaction costs and information asymmetry created market imperfections, justifying the existence of financial intermediaries, until the equilibrium la Arrow-Debreu2 model was ever achieved. Information asymmetry has a causal link with transaction cost (participation cost) due to incurrence of fixed cost for monitoring financial markets, which these financial intermediaries could facilitate with lower costs due to economies of scale and specialised knowledge. Revolutions in information communication technology and homogenisation of financial markets, lead to reduction in information gaps and thereby transaction cost. This however did not
1

Principles

See generally F. Allen, A.M. Santomero, The Theory of Financial Intermediation, (1998) 21 Journal of Banking & Finance, 1461- 1485 2 See Bert Scholtens and Dick van Wensveen, The Theory of Financial Intermediation: An essay on what it does (not) explain, (SUERF Studies: 2003/1) ISBN 3-902109-15-7; It is described the as a world where savers and investors could easily find each other due to perfect market information and non-existence of discriminatory costs for trading. It also contrived a world where financial instruments are homogeneous; there is common expectation of all market participants and no costs of insolvency.

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deter the growth or importance of financial intermediaries. Hence recently there has been a paradigm shift in theory, attributing more importance to risk management for creating EVA by financial intermediation.3 The importance of financial intermediation grew proportionately with the increasing need for risk transformation. By risk, reference is made to maturity risk, counterparty risk, market risk, income expectancy risk.4 These risk elements had a significant impact on the firms financial health and the cost-benefit analysis primarily favoured transaction cost over insolvency cost. The other factors influencing the drive for risk management are: managerial self-interests; non-linearity of taxes; and capital market imperfections. The specialised knowledge of financial intermediaries facilitated the smoothening of cashflows where imperfections in capital markets caused high volatility in stable earnings. This necessitated the payment of risk management fees to these specialized and knowledgeable financial intermediaries.5 On the other hand, market imperfections are also responsible for the thriving of financial intermediaries. Even though financial innovation and consolidations bring about homogeneity6 in the financial sector there is a continuing effort by financial intermediaries to de-homogenize, by carving out niches for their clients creating a dynamic market with tailor made financial products facilitating risk transformation through their balance sheet and off-balance sheet structures.7 The theory of EVA by the financial intermediation is not without criticism. Due to their growing importance there is an argument that misallocation of resources from the
3 4

See F. Allen, A.M Santomero (n1) See Bert Scholtens and Dick van Wensveen (n2) pg.34 5 See F. Allen, A.M Santomero (n1) pg. 1475-1477
6

Homogenization refers to more standardisation across financial functions, institutions and financial products. See generally Wolf Wagner, The homogenization of the financial system and financial crises, (2008) 17 Journal of Financial Intermediation 330356; the article asserts that risk diversification can be achieved through financial innovation in a homogenous financial sector. However firms plan less to counter the liquidity risk of investing in diversified portfolios, which to a larger extent consists of risky projects. 7 See Bert Scholtens & Dick van Wensveen (n2) pg. 28-39. The article analogizes the principle of creative destruction explained by Schumpeter, where value creation lies in the creating new and different markets.

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production sector to the financial sector, resulting in excessive profits to financial intermediaries. The alternative is a regulatory policy of subsidising liquidity hoarding to set the proper pricing for financial inputs for production sector.8 While a perfect market is non-existent, justifying the continuing need for financial intermediation, the theoretical development suggests financial intermediation should be checked from being too important or excessive pricing for financial inputs. 1.2 Traditional Banking System vs. Shadow Banking System A historical analysis of the developments in the financial systems shows a rapid change from purely bank-based systems to increasingly market-based systems. The bank-based view is more effective for growth in the early stages of economic development, while the market-based view presumes financial development by financial innovation and long run growth prospects. Contrastingly, law and finance view9 attaches less relevance to bank-based or market-based view, rather supports better legal enforcement of financial contracts as essential for financial development, which is discussed later on.10 The market-based financial intermediaries represented by the shadow banks11, through the mechanism of securitisation, has facilitated external financing pools. They engineered the combination of idiosyncratic risks with aggregate tail risk to diversify
8

See generally Maya Eden, The Inefficiency of Financial Intermediation in General Equilibrium, 14 April 2011, MIT Department of Economics paper (pg.7, 8, 15, 16, 22, 24, 25-26) Last accessed on 20 August 2011 http://econwww.mit.edu/files/5640. It refers to liquidity endowment to be used productively later. A subsidy on unproductive savings reduces incentive for liquidity hoarding. The cost of intermediation is more costly than a tax on production or levy of a transaction tax. It helps government facilitate free transfer of capital between parties crowding out these financial intermediaries and reducing their importance. The author agrees this policy diminishes financial activity but reduces unproductive financial intermediation as well realises equilibrium pricing for financial inputs. This is a contemporary issue, given the EU proposal for Financial Transaction Tax (FTT). 9 See infra section head title law and finance: need for financial regulation 10 See generally Ross Levine, Bank-based or Market-based Financial Systems: Which is better?, (2002) Working Paper 9138 National Bureau of Economic Research. Last accessed on 20 August 2011 http://www.nber.org/papers/w9138. The article builds an empirical model based on assertion that UK and US are market-based, while Germany and Japan being bank-based. Market-based system is a more integrated system impossible to separate banks and market systems, in their credit creation function. 11 Shadow banks are non-banks that conduct bank like activities, but are usually not regulated like banks Independent Commission on Banking Interim Report Consultation on Reform Options 2011 Pg.26. Paul McCulley of PIMCO was the first to coin the term shadow banking in the Jackson Hole conference in 2007 WIKIPEDIA accessed at http://en.wikipedia.org/wiki/Shadow_banking_system

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the risk among the market participants. Debt issuance against such pools was priced as riskless finance, without realising the real nature of risk underlying these debt instruments. Re-securitisation of those pools facilitated a secondary market of short term pools of liquidity. On an adverse interaction of the tail risk events, these intermediaries experienced failure due to risks exposure on their balance sheet level and as a group, failure lead to systemic risks. At the same time, banks which relied on this originate-to-distribute model did not get the backing from the external financing pools in adverse situations exacerbating the systemic risk and making the financial system extremely fragile.12&13 Moreover market-based intermediaries created windows of liquidity through balance sheet growth without ex ante explicit government support, which in adverse conditions, stimulated a balance sheet led financial crisis.14 The key distinction between traditional banks and shadow banks is that traditional banks finance themselves by taking deposits from the public, making them eligible for central bank support and deposit insurance whereas, shadow banks finance themselves by capital markets and money markets. However, while traditional banks enjoy de jure access to Government support, shadow banks may have de facto access to Government support.15 In last few decades there has been a blurring of borders between a bank and non-bank financial intermediation activities, especially in market-based systems. The Glass-Steagall Act, 1933 mandating separation between banks and investment banks is considered to have marked the birth of shadow banking system. However the consolidations drive in the US after the Gramm-Leach-Bliley Act, 1998, which was last
12

See generally Nicola Gennaioli, Andrei Shleifer, Robert W. Vishny, A Model of Shadow Banking, (2011) National Bureau of Economic Research Working Paper 17115, Last accessed on 20 August 2011http://www.nber.org/papers/w17115; In an empirical model for risk diversification and leverage by the shadow banking system, the optimal model by liquidity management and proper pricing of debt has been explained. Idiosyncratic risk refers to the non-systemic risk associated with the project loans originated. Tail risks are usually low probability events like crises that can cause systemic crisis to make the financial system extremely fragile. 13 See John Goddard, Phil Molyneux and John Wilson, The financial crisis in Europe: evolution, policy responses and lessons for the future, (2009) 17 (4) Journal of Financial Regulation and Compliance 362-380. IMF reported an estimate of $2.7 trillion of write-downs for US originated assets by bank and financial institutions. To restore bank capital-asset ratios it required nearly $275 billion and $325 billion in the US and Euro respectively. 14 See generally Tobias Adrian and Hyun Shin, The Changing Nature of Financial Intermediation and the Financial Crisis 2007-09, (2010) 2 The Annual Review of Economics 603-618 15 See infra chapter 2

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in the series of deregulation, facilitated creation of global financial conglomerates. Even in Europe, cross-border banking and passporting of financial products encouraged the creation of Special Purpose Entities (SPEs) which were financial interests of giant financial conglomerates. The failure of parent threatened the demise of the SPE leading to systemic risks. 16 This per se led to the moral hazard in the form of post ante explicit and implicit Government guarantees for too-big to-fail financial conglomerates. 1.3 Credit Intermediation theory Maturity transformation; Credit

transformation; and Liquidity transformation Credit intermediation is the creation of credit supply in the financial system through the process of financial intermediation. Credit intermediation involves: i) maturity transformation; ii) liquidity transformation; and iii) credit transformation. Maturity transformation aims at overcoming maturity mismatch between long-term assets and short term financing; liquidity transformation is the usage of liquid instruments to fund illiquid assets; and credit transformation refers to the process of enhancing credit quality of debt using priority claims to distinguish between senior and junior tranches.17 Maturity transformation The biggest criticism of modern day system of maturity transformation was that it led to private money creation by shadow banking system, rather than the Government. Maturity transformation was facilitated by a system of short-term money market

16

See Kenneth W Dam, The Subprime Crisis and Financial Regulation: International and Comparative Perspectives (2010) John M Olin law& economics working paper no.517 The Law School of University of Chicago. Pg.27-30. Also see infra Pozsar, Adrian, Ashcraft and Boesky (n17) pg. 30-34 17 See Pozsar, Adrian, Ashcraft and Boesky, Shadow Banking, (2010) Staff Report no. 458 Federal Reserve Bank of New York July 2010, Pg.8 . The importance of credit-creation is emphasized in the recent World Economic Forum projection; sustainable credit level has to double to $103 trillion in the next ten years to match the economic growth projections

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instruments, some of which qualified as monetary aggregates18, helped to create a constant financing for long term assets. Large US money market funds also increased their exposure in European banks short term credit instruments, exposing the crossborder interconnectedness of the shadow banking system. While there in no evidence to suggest explicit influence of the shadow banking system in money creation, other than being financial intermediaries or facilitators in money markets, nevertheless the interconnectedness of banks with money markets makes them a force to be reckoned. 19 The argument favouring this public-private partnership or government-private party partnership in maturity transformation, was that it could add economic value by reducing maturity risk, within a system of deposit insurance and risk constrains on generation of money claims. In the context of modern day financing structure of firms cost-benefit analysis of maturity transformation is linked to cost of market failure and cash management through riskless short term debt finance to long term equity. Historically the US policy of risk-constrained-regulations within a support system of FDIC insurance; and, the BoEs LOLR policy combined with FSCS insurance, promotes this ideology of maturity transformation. The Dodd-Frank Act advocates a system of Orderly Liquidation modelled on FDIC as a receiver guided by enterprise value considerations. Interestingly the new liquidation regime obliterates the difference between money claims based on their maturity, changing the dynamics of cost-benefit

18

These money market instruments were counted monetary aggregates, as cash outside banks, in money supply calculation. In UK, the BoE categorized them under M4 and in the EU as M3. See WIKIPEDIA http://en.wikipedia.org/wiki/Money_supply. 19 See Morgan Ricks, Regulating Money Creation after the Crisis, (2011) Volume 1 Harvard Business Law Review Pg. 75-143, Also See Gorton and Metrick, Securitised Banking and Run on the Repo,(2010) Yale and National Bureau of Economic Research; The principle is that private actors should not influence a public duty. The public duty of money creation can be kept in check with a combination of policy measures like government interventions and bank regulations on capital adequacy, leverage and prudential norms. The authors describe the role of the repo markets as money equivalent liquid assets. The run on repo markets from 2007-08, and increased haircuts on repo actually created a run on bank like situation, squeezing money markets. But arguably these were market makers merely facilitating the transactions, while banks were equally knowledgeable and sophisticated participants.

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analysis for maturity transformation in favour of quality of collateral (say highly monetizable repo collateral).20 Despite insufficient evidence that shadows banks can actually create private money, it is one of the prominent reasons alleging that shadow banks are not adequately regulated.

Credit transformation Credit transformation purports to reduce credit risk by increasing credit quality and influencing the increase of credit supply. The mechanism of tranching or tiering of risk in a waterfall-based CDO facilitates credit worthiness improving the rating for senior tranches. These senior tranches provided assurance of seniority in waterfall structure for interest and principal payments as well as pre-determined leverage ratio to collateral level (overcollateralization). Financial innovations in credit risk diversion also securitised cashflows carrying different risk profiles like mortgages, credit card receivables, student loans into RMBSs, CMOs, CDOs and CLOs. These were further resecuritised using CDO squared transactions, leveraging on rating improvements and interest rate spreads. Cashflow CDOs were intended to be true sale securitisations21 with complex waterfall structures on the backing of non-standardized boilerplate contractual terms. These were backed with synthetic CDS (Credit Default Swaps) used in the re-securitisation process, which provided insurance/ credit risk transfer, in case of credit default improving the rate spreads.22 The legal certainty of these waterfalls can be questioned in the case of Goldman Sachs when it invoked its sole discretion to retire junior tranches at the expense of more senior tranches in Abacus synthetic CDO issues (2006 series). This circumvention led to
20 21

See supra Morgan Ricks (n19) pg.109-114 and 122-136 See infra chapter 4 on true sale securitization effected by title transfer like transactions. 22 See Schuyler Henderson, Regulation of Credit Derivatives: to what effect and for whose benefit? Part 1, (2009) Volume 24/Issue 3 Journal of International Banking and Financial Law147.

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a downgrade in rating from original AAA rating to CC by Fitch.23 The most important issue still remains that, this form of credit intermediation does not necessarily reduce credit risk, except for increasing credit supply. Credit derivatives like CDS increases credit supply for longer term borrowers being large firms at an increased cost and increased maturity.24 Credit risk transfer (CRT) by the medium of securitisation/credit derivatives reduces the incentive of the loan originator to monitor risks effectively on individual loans. Practically optimal CRT can be achieved through a portfolio of loans, as facilitated by shadow banks by loan warehousing, rather than on an individual loan basis. Hence regulatory policy strategy should be a combination of prudential regulations for due diligence and optimum level of risk retention, by the loan originator so as to preserve monitoring incentives; as well as an optimum collateralisation level for credit enhancement, to make CRT techniques effective.25An example for prudential regulation is FSA BIPRU 9 based on the EU CRD rules, which prescribes prudential rules for calculating regulatory capital for tranched securitisation positions. However there may be a need for adequate guidelines for due diligence by loan originators and internalising of risk mitigation at originators level. 26 Liquidity transformation

23

See Jody Sheen Goldman Pays Junior CDOs Before Junk Senior Classes (Update2) (Bloomberg 12 November 2009) accessed last on 20 August 2011http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_NUiTt__oI4&pos=4. These were part of the CDOs of $1.6 billion by repackaging credit default swaps. This event has investment firms scrutinizing the contractual terms of these CDO issues, to explore weakness in such contracts. 24 See generally Beverly Hirtle, Credit Derivatives and bank credit supply (2009) 18 Journal of Financial Intermediation 125-150, where the author uses an empirical model analysing a micro data set of individual corporate loans and the effect on terms for term loans and commitment loans. Banks utilize credit derivatives and CDOs warehoused in conduits facilitated by shadow banking systems, to enhance their lending ability. The inherent credit risk diversification by tranching may create more returns for banks than significantly improve credit supply or reduce credit risk. 25 See Gabriella Chiesa, Optimal credit risk transfer, monitored finance, and banks, (2008) 17 Journal of Financial Intermediation 464-477. Banks /Loan originators have a high incentive for credit risk incentive because of higher costs of bankruptcy and information asymmetry at originators level of bad loans. This also raises the problem of time inconsistency/ commitment, once the outside finance is raised. The article thus emphasises more responsibility to the originator than the shadow banks facilitating the credit risk instruments. (Pg. 465, 466, 472, 474-476) 26 See infra chapter 3 - UK FSA BIPRU 9 and EU CRD 2 and CRD 3 regime.

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The modern perspective of liquidity is more associated with financial balance sheet growth. Liquidity transformation through the provision of highly liquid short term finance market along with maturity matching of cashflows, influenced increase of leveraging in the financial system. In turn liquidity has a direct influence on increasing asset pricing, distorting the adequacy of risk assets backing such leverage enhancement, making leverage procyclical. There is evidence of leverage growth in investment banks balance sheet positively proportional to increase in balance sheet growth. The failed investment bank Lehman Brothers balance sheet was more mark to- market making them highly vulnerable to falling asset prices in a crisis situation. This also the questioned the solvency capital requirements and the model of value-at-risk (V-a-R), under SEC net capital requirement reported by investment banks in their 10K and 10Q reportings.27In 2004 SEC had changed its net capital rules, to allow net capital to be computed at CSE Holding Company level (Holding Companies of regulated brokerdealers) in response to the EU Financial Conglomerate Directive exemption to non-EU financial conglomerates. This however resulted in ever increased leverage of investment banks, which may have been facilitated by taking away excess net capital of regulated broker-dealer subsidiaries to invest in other riskier businesses.28 At the same time, a micro perspective of procyclical leverage reflects a constant conflict between debt-equity mixes in a firms financing structure. Issuance of debt and convertible debt are countercyclical in events of uncertainty; while equity issuance and equity kickers are procyclical. This tendency for shifts in leverage can be seen in debt-equity structure of firms, from bad times to good times. Moreover differences in

27

See Tobias Adrian and Hyun Shin, Liquidity and Leverage, (2008) Staff Report no. 328 Federal Reserve Bank of New York, Pg. 5, 7, 13-14, 20-26. Lehman Brothers balance sheet has reported to having largely short-term marked to market positions than long term positions and an equity of only 4%. The US Securities and Exchange Commissions (SEC Rule 15c3-1 and 15c3-3) uniform Net Capital Rule was created in 1975, to enable broker-dealers to fulfil their credit obligations. 28 See infra chapter 2 - SEC net capital rule change for broker-dealer and EU Financial Conglomerate Directive. The SEC ended the CSE regulatory regime on 26 September 2008. Some large investment banks have converted to BHCs regulated by the Federal Reserve. http://sec.gov/news/press/2008/2008-230.htm

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tax treatments also make equity more expensive.29 Contrastingly, mandatory convertible contingent capital is countercyclical, to reduce the indebtedness of the firm in event of crises. The terms of contingent capital conversion can be set at a certain debt-equity ratio or EBDITA-interest ratio. However these contingent capital contracts still leave room for uncertainty in times of potential insolvency.30A legal parallel may be drawn to debt-equity swap in cram down situations in a scheme of compromise or arrangement under Company law. In case of inevitable insolvency there will be a need to cram down against the dissenting sub-ordinated creditors and perhaps even shareholders. It may entail an inter creditor agreement specifying the valuation, waterfalls among senior and sub-ordinated debt; nevertheless the risk of litigation is still open, on procedural technicalities of law in such schemes of arrangement and compromise. Alternatively, a pre-pack administration or PECO like structure may be visualised, at the advent of uncertainty/potential insolvency. The legal validity of such structures needs more certainty by way of legal reforms under national insolvency laws.31 Objectively, contingent capital structures should aim at preventing firms insolvency by securing additional financing under better debt-equity ratios, rather than achieving orderly resolution. To conclude it can be said that, regulatory reform should be focussed on reinforcing liquidity provisions rather than just setting norms for leverage. The stability of liquidity in the financial system, in an economic sense rather than in legal or statistical characterisation, should be the benchmark for assessment of regulatory reforms. 1.4 Structural reforms in financial sector

29

See generally Erel, Julio, Kim and Weisbach, Macroeconomic conditions and the Structure of Securities (2010) Fisher College of Business Working Paper Series. Last accessed on 20 August 2011 at http://www.ssrn.com/abstract=1396355 30 See Avgouleas, Goodhart and Schoenmaker, Living wills as a catalyst for action, (2010) Wharton Financial Institutions Center, Working Paper10-09, Wharton School, University of Pennsylvania, Philadelphia 31 See Geoff ODea, Craving a cram-down: why English Insolvency law needs reforming, 10 Journal of International Banking and Finance Law 583.For PECO see infra (n101) and for prepack see infra (n104 )

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The financial crisis of 2007-09, was a balance sheet crisis rather than a liquidity crisis. Excessive liquidity was influenced by leverage and balance sheet expansion, but falling of asset prices caused deleveraging, deteriorating financial institutions capital to insolvency. Further interconnectedness of the financial system intertwined the balance sheets of banks and shadow banking institutions, making them susceptible to the others failures. This led to the advancement of reforms options like structural separation of banks from investment banks otherwise called the Volcker Rule or ring fencing of retail banks, shielding retail deposit-funded banks from the failure of investment banks. But this structural separation still does not address the systemic risks that the shadow banking system could still cause to the financial system; their role and importance in the financial credit creation still makes them too-big-to fail. 32 Another notable aspect observed during the financial crisis is the level of contagion of a systemic crisis due to financial system interconnectedness. In April 2011, the G-20 supported Financial Stability Board (FSB) issued a discussion paper setting out the scope of regulation for shadow bankings credit intermediation activity and addressing systemic risk. The interconnectedness of banks to shadow banking could be in the form of: i) banks dependant on shadow banks for their maturity and liquidity transformations; and ii) banks being investors and / or traders in financial products for hedging purposes or even with proprietary trading interests. Either way, this could exacerbate procyclical leverage in good times and create contagion of risks in bad times.
33

Moreover under increasing regulatory burden on banks, regulatory arbitrage could

distort incentives to move away risks to the shadow banking sector. FSB suggests a system of regulatory oversight, both on a global and national level, of macro and micro monitoring of systemic risks. This could be to monitor risks based on: the size
32

See Rosa Lastra and Geoffrey Wood, The Crisis of 2007-09: Nature, Causes and Reactions, (2010) 13(3) Journal of International Economic Law 531-550, Pg. 531-537, 539 and 547-550. 33 See Gorton and Metrick (2010) (n 19) For instance the run on repo markets signaled the first start of problems in August 2007 and later on led to the rescue of Bear Sterns in early 2008, till it culminated in the failure of Lehman in late 2008.

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and growth to GDP ratio; specific financial markets; intra-group activities; and counterparty risks to banks. A complementary macro-prudential overview can address broadly systemic risks by measures for mitigating procyclicality and /or strengthening market infrastructure to reduce contagion risks.34

1.5 Moral hazard, Conflicts of Interests and Gatekeepers duties The crucial debate that emerged from the current crisis is the aspect of moral hazards in bail-outs by Government at the expense of tax payer. There are two angles to the aspect of moral hazard: i) Explicit or implicit Government support distorts incentives for adverse selection; and ii) Misalignment of incentives for decision makers to invest in risky ventures. Systemically Important Financial Institutions (SIFI) in the case of banks were bailed out based on LOLR principle; and non-bank financial institutions were given support to prevent further deterioration in the financial markets, especially in the aftermath of Lehman collapse. In the case of risky decision makers, there has not been enough prosecution, proportionate to the financial damage caused. Moreover the financial crisis revealed the growing economic disparity between the top management and lower levels of management, despite the fact it was preceded by an economic boom. Post crisis reforms have advocated mitigation in the form of; a levy/ charge on assets for SIFIs; and, a fixed ratio between CEO and employees in the lower strata.35 The grey area in the theory of financial market making is the principle of conflict of interest. The same can be analysed under two aspects: i) conflict of interest by safeguarding the interest of the client, while undertaking a transaction; and, ii) potential

34

See Financial Stability Board, Shadow Banking: Scoping the Issues, (FSB 12 April 2011) Last accessed on 20 August 2011 http://www.financialstabilityboard.org/publications/r_110412a.pdf. 35 Item 402 of Regulation S-K under the US SEC Act and EU CRD 3 requires disclosure of ratio between CEO and other employee norms and certain claw back provisions. An argument that bail-outs may be profitable to the Government to purchase blue chip companies in knock-down prices is still not a mitigating factor for the moral hazard by bailing them out.

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conflicts of interest when one agency handles the advisory function for competitors or parties for both sides of the transaction. The first aspect was widely debated in the Goldman Sachs debacle by selling credit protection for the hedge fund Paulson & Co. whilst selling a reverse position in Abacus CDOs, allegedly knowing them to fail. The economic rationale for conflicts of interest regime is to reduce agency costs and information symmetry when knowledgeable and reputed dealer facilitate such transactions. However the legal position at the time did not clearly indicate any fiduciary liability to sophisticated investors in an arms-length (principal-principal) transaction between knowledgeable parties. The firm however settled a fine of $550 million, without admitting/denying allegation of securities fraud. The Dodd-Frank Act has introduced a regime of material conflict of interest in underwriting and securitisation transactions.36 The second aspect of conflict of interest has been examined in the Citigroup case, where implementation of Chinese walls protect the interest of parties on both sides of the transaction, by walling -off the advisory, if another vertical in the same group enters into a proprietary interest on their own. However the ruling has upheld the concept of Chinese walls citing caution requiring strong evidence to demonstrate effectiveness of such measures.37 The role of gatekeepers like credit rating agencies (CRAs) and auditors in reducing distortions of information asymmetry, was widely criticised post the crisis. CRAs assigned high credit ratings in securitisation deals like CDOs mispriced risk leading to flawed CRT at lower cost. Further under the Basel regulatory capital regime, credit rating enabled to reduce risk weighting of assets, thereby reducing levels of regulatory
36

See Andrew F. Tuch, Conflicted Gatekeepers: The Volcker Rule and Goldman Sachs, (2011) Discussion paper 37 Harvard Law School (John M. Olin Centre for Law, Economics, and Business Fellows Discussion Paper Series. 37 See Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty Limited (ACN 113 114 832) (No. 4) [2007] Federal Court of Australia 963; Referring to Australian Securities and Investments Commission v Citigroup Global Markets Australia case: The facts of the case was that Citigroup trading division had purchased shares of a potential target company to be acquired by a company being advised by Citigroups investment advisory division. Both the claims of conflict of interest and insider trading failed. However while giving legal sanction in this case, for the concept of Chinese wall between various divisions of Citigroup, the Judge cautioned on the defence of Chinese walls and ruled in favour of Citigroup based on the facts of this case where it was demonstrated that proper controls that were in place.

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capital and cost of finance. Even more dangerous were the responses to a downgrade in ratings triggering higher discounts on asset prices; deleveraging and liquidity crunch were the consequence. The second issue was a potential conflict of interest in the issuer payer model for credit ratings. The CRAs were obligated to the issuers of securities and in some cases pressurized38, to assign higher ratings to see deals through. The suggested reforms for CRAs is to reduce concentration in the ratings markets; revamping the issuer payer model; reducing sole-reliance on credit rating opinions in investment decisions; more robust penalty framework for misstatements in securities issuances due to inadequate due-diligence standards; and, perhaps disclosure/ disclaimer of opinion in case of conflict of interest of the dealers in securitisation deals. With respect to legal issues, CRA liability should be brought under fiduciary-like-liability giving them the status of experts rather than their recommendations being treated as opinions.39 With respect to Auditors, precedence can be taken in the case of J P Morgan Securities where PwC faces heavy fine for failing to report to the FSA that client assets were not properly ring fenced. The Accountancy & Actuarial discipline board remarked the lack of due skill, care and diligence and applicable technical and professional standards expected out of a professional firm.40 An interesting remark about raising the bar for technical and professional standards, could invite interpretation issues which enforces the idea that accounting profession needs to be technically updated with complex financial instruments, regulations and venture to prevent possible loop holes, which increases their duties from historical standards.

38

See Katy Watchel, Emails Show A Ratings Agency "Screwed With Criteria" To Rate AAA And "Get The Deal" From Intimidating Bankers (Business Insider 14 April 2011) Last accessed on 20 August 2011 at http://www.businessinsider.com/moodys-sandp-senate-report-financial-crisis-ratings-agencies-2011-4.
39

See generally Peter Yeoh, Structure Finance: a matter of gatekeeping? (2010) Law and Financial Markets Review September 2010 499-506. 40 See Simon Bowers, PricewaterhouseCoopers faces fine over JP Morgan's client assets (Guardian 15 August 2011) Last accessed on 20 August 2011 at http://www.guardian.co.uk/business/2011/aug/15/jp-morganpricewaterhousecoopers-clent-assets.

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1.6 The law and finance view: the need for financial regulation The law and finance view of La Porta model, for judicial checks and balances guaranteeing economic and political freedom reinforces the imperativeness of a robust legal system. Theories suggest that stronger legal systems in investor-based countries increased investor interactions and down side risk protection; also reducing agency costs and risk based pricing.41 This may have influenced the pervasiveness of International Financial Law as evidenced by rapid migration across the globe of fundamental principles of financial regulation, especially in securities law regime42, and in private law concepts. However, there still exists complexity of different jurisdictions having different public law regimes which may trump the parties deal choices under private law. The biggest fallacy lies in the differences in legal characterisation of financial products/ processes under different points of contact of legal interactions: like hard law public legislations; soft law global regulations; and private party agreements.43 The weakness of financial regulation may lie in the jurisprudential characteristics of financial law. Financial law making is not strictly based on natural truths or theories of natural justice or moral value justice systems or legal positivism, unlike other branches of law. Hence financial law may represent a regulators common-sense to deal with a particular situation. Complex technical rules in financial regulations amplify the inherent incentives to circumvent financial regulation. Hence the ideal approach should be, simplified financial rules based on principles of socio-economic development;
41

See Bottazzi, Da Rin and Hellmann, What is the role of legal systems in Financial Intermediation? Theory and evidence (2009) 18 Journal of Financial Intermediation 559- 598. 42 See Donald C. Langevoort, Global Securities Regulation after the financial crisis,(2010) 13(3) Journal of International Economic and Trade Law 799-815, Section II describes the Europeanization of US Securities law. The EU common market pass-porting regime for financial products, services and investment flows, underpins the growing pervasiveness of financial law. 43 See Paul Sebastianutti, What is this thing called International Financial Law? Part 5, (2009) Law and Financial Markets Review September 2009 461-478; Financial law has been widely pervasive in securities law in areas like prospectus information, take-over code, corporate governance, insider-trading, and manipulative and fraudulent market devices. However public policy on betting and gambling extrapolations to financial laws can sometimes recharacterize instruments like swaps and derivatives, trumping parties intentions under the deal. Points of contact of legal interactions under the regulatory regimes are generally: market-based; bank-based; Industrial cross-holding based; and State-center based.

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sustainability of financial system; and proof against regulatory arbitrage. The costbenefit of financial regulation should be measured on both socio-economic parameters for development. There also should be clearly defined fiduciary relationships and liabilities specified as a deterrent to circumvention of rules.44

1.7 Concluding Remarks The incentives of traditional banks, which perform a pseudo public duty function, are different from that of private profit orientation of shadow banks. Any regulatory framework should be conceptualised keeping in mind this incentive structure or in other words business model of shadow bank participants. The efficient market hypothesis has been challenged since the crisis. Hence the self-interest of participants needs to be checked for the larger public interest. In the pre-crisis era, risk management function of shadow banking was pushed to its limits. The emerging philosophy for risk management is to internalise certain amount of risk by the loan originator, so as to preserve monitoring incentives and reduce systemic risk by in-house risk mitigation strategies. In the short term the focus of regulatory authorities is to strengthen banks to make them more resilient, however in the long term the financial system along with shadow banks should be made resilient to risks because of their vital role in the financial stability. Shadow banks in the constant move to seek niches for specialisation can be tackled by focussing on their business model and risk-reward relationships to check excessive profiteering or becoming systemically important.

44

See Phoebus Athanassiou, Financial rules: why they differ, where we got them wrong and how to fix them, (2010) Law and Financial Markets Review May 2010 279-285.

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Chapter 2 Business Model Perspective of Shadow banking system This chapter defines the shadow banking system from a business model perspective and identifies the participants in the shadow banking system. Further there is an analysis of the structure of the shadow banking system by two aspects: Systematically Important Financial Institutions (SIFIs) and Systematically Important Financial Markets (SIFMs). 2.1 The business model perspective The analysis of value-added input-output model in the context of a manufacturing value chain, would involve of a study of the interactions between variables like cost structure, profit margin spreads, market entry barriers, market segments, and market players. The same analysis may be extrapolated to explain the business model of the shadow banking system and its value propositions. The term business model can be conceptualised as set of propositions having an economic rationale to explain a firms structure and activity. Over the last few decades, there has been a shift in banking business model, from portfolio lending to originate-todistribute models, attempting to remove the risks of term and rates from their balance sheets to external systems. These risk transfer model created an economic rationale for the shadow banking value chain. The juxtaposition of the shadow banking value chain in relation to the banking business models is in fact the structure of modern financial architecture. This financial architecture embodies the interaction between regulations, market liquidity, and firms financing structure. Based on business principles like economies of scale and arbitrage functions, over time the blend between commercial and investment banking gave birth to universal banks and LCFIs.45

45

See generally Jos Gabilondo, So now who is special? Business model shifts among firms that borrow to lend (2009) 4 Journal of Business & Technology Law Pg.261-282

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It is difficult to define where the border of shadow banking starts and where it ends: it would be easier to define territory of shadow banking system, in the simplest terms by distinguishing them from traditional-deposit-taking banks or pure play insurance firms. The consensus view is to include all not-so-regulated financial intermediaries.46 In the context of credit intermediation, shadow banking performs maturity, liquidity and credit transformation, by means of securitisation and warehousing in a continuous chain of activity. Pozsar et al has identified the value chain, as a step-by-step functional activity of; i) loan origination, ii) loan warehousing, iii) ABS issuance, iv) ABS warehousing, v) ABS CDO issuance, vi) ABS intermediation, and vii) wholesale funding. Shadow banking may be visualised as a parallel universe to banking, consisting of the above mentioned functional activities, market players and specialised entity structures. The market players are MMMFs, DBD, credit hedge funds, privateequity funds and securities lenders. The entity structures used in the processes are; finance companies, single and multi-seller conduits, SPVs, SIVs, LPFCs. Shadow banks have today become a vertical slice of the traditional banking credit intermediation system, where they have a presence from loan origination to wholesale financing money markets. They are also vital market makers facilitating price discovery, hedging of price fluctuations, risk transformation, maturity matching; creating depth and increasing stability by volume of transactions.47 The mechanism of structured credit facilitated by the shadow banking system had two variants: i) maturity matched; and ii) maturity mismatched. The process of maturity matched structured credit involved term liabilities issued against securitised obligations,
46

What is the Shadow banking System? Standard & Poor report (18 March 2011), Shadows No More: The Shadow Banking System Steps into the Spotlight, defines shadow banking as a system of finance outside the regulated deposit banks, dealer-brokers, bond funds. It seems to include ABCP conduit, MMMFs, private funds, hedge funds, CLOs, finance companies. Pozsar, Adrian, Ashcraft and Boesky (n17) includes GSEs like Fannie Mae and Freddie Mac in the shadow banking system. So is the bright-line being not-so-regulated community of financial intermediaries? For LCFIs see infra section titled, Systematically Important Financial Institutions (SIFIs) describing LCFIs which is a group structure of deposit taking banks, insurance entities and shadow banks all under common control. LCFIs are bigger than universal banks. FSB (n 34) is still in the process of defining of shadow banking system. 47 See Pozsar, Adrian, Ashcraft and Boesky (n17) pg.11-12

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warehoused in SPVs. Maturity mismatched pools warehoused in SIVs, contained term assets financed by short term notes. These mismatched pools had liquidity puts and credit puts in the form of credit lines and asset sales. At this level, maturity, credit and liquidity transformation is achieved. Further down in the process of securitisation, like ABS CDOs and CDO squared, funded by maturity mismatched ABCP/ repo performed only credit and liquidity transformation. Their credit risks were often covered by backup lines from banks or credit default derivatives (CDS). Hence in business model terms, credit creation has shifted from pooling and matching funds to an arbitrage model of market liquidity driven balance sheet model. Even business models of banks and Government sponsored Entities (GSEs) approach to have shifted from performing pseudo public duty to portfolio management, to enhance returns on equity (ROE). The maturity, credit and liquidity risks in this new business model scenario, leant on direct and indirect credit enhancement from the public sector, when the counterparties were depository institutions, pension funds and GSEs. 48 2.2 Systemically Important Financial Institutions (SIFIs) Economies of scale and regulatory arbitrage led to the traditional banks and financial intermediaries consolidating to form financial conglomerates often called Large and Complex Financial Institutions (LCFIs) 49. The structure of the LCFIs usually consist of a mix of regulated businesses like deposit insured banks and insurance, along with other verticals like with investment advisory, asset management and proprietary trading. The major incentives which fuelled the LCFI structure was: i) increased credit creation dependency on the capital market avenues like securitization and commercial paper, making traditional banks less special; ii) control over /access to various market services

48

See Pozsar, Adrian, Ashcraft and Boesky (n17) pg.8-10, 15-20. Also see Boone and Johnson, Will the politics of global moral hazard sink us again?, (2010) Chapter 10 The LSE Report- The Future of finance 247-288 49 There can be other form of designated SIFIs which are not necessarily LCFIs. Certain transnational firms (nonfinancial) transact in hedging transactions or captive financing transactions which may have similar activities to shadow banks. However they are considered as end users of funds and not financial intermediaries.

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like insurance, banking, asset management and advisory enables these LCFIs to provide a host of services to clients or even influence cost for these services (financial supermarkets); iii) regulatory reasons, for e.g., the amendment to SEC net capital rules in 2004, permitted LCFIs to leverage on capital strength and LOLR backstop of regulated business to raise more funds for the relatively less regulated ones; iv) Toobig-to-fail incentives increased their competitiveness at the cost of the taxpayer. 50 With LCFI business models, there is always a trade-off between profitability and safety; till the advent of the 2008 crisis, LCFIs like Goldman Sachs and Morgan Stanley were functioning as investment banks regulated by SEC, till they had to convert to Federal Board regulated Banking Holding companies to avail Federal Reserve support. This again reiterates the too-big-to -fail position of these LCFIs.51 Recently EU regulatory regime qua Financial Conglomerates Directive, proposed changes seeking reforms for LCFIs: both sectorial regulations (banking or insurance or UCTIS firm or MiFID firm) and supplementary regulation applied to group as a whole. However based on certain group risk parameters smaller groups may be waived from supplementary regulations.52 Shadow bank can be classified based on the nature of its participants: internal as in the case of LCFIs; or external like diversified broker-dealers (DBDs). Internal shadow banks like LCFIs use their balance sheet to facilitate credit intermediation and expanding their balance sheet size by consolidating bank and specialised non-banks.

50

See Arthur Wilmarth Jr., The Transformation of the US financial services industry. 1975-2000: Competition, Consolidation, and Increased Risks, (2002) Volume 2002 University of Illinois Law Review 215- 476, Pg. 227235.For change in the SEC net capital rule see supra (n 27) 51 See Goodhart and Lastra, Border Problems, (2010) 13(3) Journal of International Economic Law 705-718. Also see Arthur E Wilmarth Jr., The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-to-Fail Problem, (2011) Volume 89 Oregon Law Review 951-1058. The Federal Reserve Boards powers to help individual SIFIs has been constrained by Sec 1101 and 1105 of the Dodd-Frank Act, but there still remains a window of opportunity for funding under Federal Reserve Section 13(3) to broad based group of solvent institutions albeit requirement endorsement of the US Congress. Moreover LCFI held depository banks can continue relying on the Government LOLR facilities.(Pg. 1000-1006) 52 See Better Supervision of financial conglomerates, (2010) EU Focus 276 pg. 20-21. These entities are already subject to CRD, Solvency II regulations for credit institutions and insurance within the group. The Joint Committee is also proposing to include certain off balance SPV under the regulatory purview. The extended focus is to look into group risks, identifying financial conglomerates and better co-ordination between national and cross sectorial regulators.

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Another aspect is the cross-border interconnections of these LCFIs, between the US and EU regimes. European shadow banking was involved in credit and maturity transformation through off-balance sheet entities like SPVs and SIVs. The banks had indirect connection to these off-balance sheet entities as LOLR in crisis situation. Also they were investors in the US structured credit markets too. Further their exposures also covered dollar-euro swap contracts which were undertaken by asset management sections of the shadow banking system. The external shadow bank participants were a network of specialist non-banks by DBDs and were external to the banking system. Their key advantage was in the form of gains from specialisation and comparative advantage of relatively less regulation, which made them more flexible and cost effective than banks. Moreover these external systems also contained private risk repositories which facilitated credit risk transformation for the shadow banking and banking system.53 2.3 Systemically Important Financial Markets (SIFMs) The growing dominance of shadow banking participants in financial markets integral to the financial architecture makes it imperative to regulate these systemically important financial markets. SIFMs are designated by their importance to the financial system and their vulnerability to impose systemic risks, undermining financial stability.54 The Volcker rule has attempted to restrict funding support from banks and SIFIs, to risky shadow banking activity, but there can be large parts of the shadow bank still interconnected to banks and SIFIs, through these SIFMs. One particular SIFM activity in the shadow banking system known as the repo (Repurchase Options) market was the source of short term funding and a vital part of cash management for investment banks and banks alike, though in different proportions.
53 54

See Pozsar, Adrian, Ashcraft and Boesky (n17) pg.26-42 See infra chapter 5 (n132) on FSBs market watch on ETF stability risk issues and regulatory framework for better collateral.

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Repo markets form a part of the wholesale financing activity in the aforementioned value chain of shadow banking activity. The collateral under repo was further rehypothecated to raise additional funds and liquidity. Specialised broker-dealers and MMMFs were active market makers in this financial system. By 2007 the repo market was estimated to be $10 trillion in US and Europe, with UK repo market accounting for $1 trillion.55 In the mid 2007 till the rescue of Bear Sterns in early 2008 the repo spreads increased till it peaked after Lehman collapse. The repo spreads were tight spreads where a short variation could send deleveraging effects of systemic proportions. In the crisis the repo market funding dried up significantly fearing counterparty risks and /or collateral value risks.56 There are views expressed that it was Non Agency ABS/MBS which were significantly exposed in the run on the repo. The shadow banking system hence provided credit support for private collateral, increasing liquidity in these markets. 57 Interestingly, regulatory arbitrage also existed between US and UK repo markets. The US SEC Rule 15c3-3 imposed restrictions on brokers funding activities and Regulation T of the SEC imposed a cap on broker re-hypothecation of client assets to 140%, the

55

See Enrico Perotti, Systemic liquidity risk and bankruptcy safe harbour privileges, (2011) 4 Journal of International Banking and Financial law 187 56 See Gorton and Metrick, Securitized Banking and Run on the Repo (2010) Yale and National Bureau of Economic Research; Last accessed on 20 August 2011 at http://ssrn.com/abstract=1440752 . 57 See Krishnamurthy, Nagel and Orlov, Sizing up Repo, (2011) National Bureau of Economic Research; Last accessed on 20 August 2011 at http://faculty-gsb.stanford.edu/nagel/documents/Repo_Aggregate_June29.pdf Also see FCIC, Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (Report January 2011); Also certain privileges were given to repos in form of bankruptcy remoteness; Prior to 2005, repo lenders had clear and immediate rights to their collateral following the borrowers bankruptcy only if that collateral was Treasury or GSE securities. In the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress expanded that provision to include many other assets, including mortgage loans, mortgagebacked securities, collateralized debt obligations, and certain derivatives. The result was a short-term repo market increasingly reliant on highly rated non-agency mortgage-backed securities; but beginning in mid-2007, when banks and investors became skittish about the mortgage market, they would prove to be an unstable funding source Once the crisis hit, these illiquid, hard-to-value securities made up a greater share of the tri-party repo market than most people would have wanted FCIC report (pg.114)

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same not being as restrictive in UK. Hence these firms established subsidiaries in UK where such restrictions on re-hypothecation did not exist.58 2.4 Concluding remarks The most influential aspect of the shadow banking system is the paradigm change it brought to business model perspective of banks and public sector participants in the financial system. They facilitated liquidity by short term funding which influenced the cash management strategies of the said participants. Shadow bank participants permeated the belief that structured credit can be facilitated even by maturity mismatched formats, supported by liquidity puts and credit puts. This increased their participation in short term wholesale funding which till then was exclusively supported by the banking and public sector participants. This enhanced liquidity also led to tight spreads in the pricing of short term financing, making credit cheaper, but in the case of volatility of spreads the system was vulnerable to shocks and drying up of liquidity. Sandra C. Krieger, Executive Vice President of the Federal Reserve Bank of New York, in a recent speech rightly emphasised the need to ensure that maturity transformation and the liquidity/credit puts are priced properly. Shadow bank facilitation should reflect these economic costs and pass it along the intermediation chain.59

58

See Singh and Aitken, The (sizeable) role of re-hypothecation in the shadow banking system, (2010) WP/10/172 IMF Working Paper. In the bankruptcy of Lehman Brother Europe subsidiary (LBIE) PwC admitted that client assets were not segregated properly, see supra (n40) 59 See Sandra C. Kriegers speech on 8 March 2011, Reducing the Systemic Risk in Shadow Maturity Transformation, Remarks at the Global Association of Risk Professionals 12th Annual Risk Management Convention, New York City. For impacts of cost due to collateral requirements, see House of Lords, Parliamentary business, The future regulation of derivatives markets: is the EU on the right track? - European Union Committee, Para 81 and 105, Chatham financial says additional cost due to margin requirements, impact end users working capital estimations. On the other hand the counter argument will be that this cost is necessary to price the real economic cost for risk protection, which may have been underpriced till date.

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Chapter 3 Regulatory reforms: Macro perspectives This chapter focuses on key reforms post the financial crisis reviewing, comparing and contrasting reforms across US, UK and EU regimes, and its impacts on business models of shadow banking system. Regulation for the shadow banking still remains fragmented due to multiple regulators and the fact that LCFIs are spread across different jurisdictions. Regulatory reforms may have direct effects when targeted at shadow banking system; or indirect effects targeted at a bank or secondary market participant important to the shadow banking system. Part I concerns regulation which are institution-based like SIFIs, LCFIs and other investment firms; Part II discusses regulation targeted at market reforms which regulate SIFMs; Part III, regulation which casts the net wide to capture secondary market participants and other shadow banking entities and also discusses corporate governance reforms. 3.1 Part I - Institutions based regulations 3.1.1 Volcker Rule The rationale behind the Volcker Rule in US banking system and ring fencing in UK banking system, is to firewall deposit-insured entities from consequences of failures of the unsupported shadow banking system. The US formulation of the said rule broadly involves a system of prohibited activities (covered activities) and de minimis investment limits. In UK however the proposed system is a structurally separate and separately capitalised retail banking system; by way of subsidiarisation or similar form to be ring fenced from other entities within a larger financial group. There already exists certain

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structural limitation by way of large exposures60 in the UK and EU regime to limit counterparty credit risk for banking and investment firms.61 The Volcker rule separation of banking entities from the shadow banks is effected by quantitative and qualitative restrictions, cutting off the source of finance for shadow banking participants. The restrictions on proprietary trading takes the form of

prohibition for engaging as a principal for the trading account positions on certain covered instruments, to be disposed-off in the near term (presumably short-term trading). These instruments of proprietary trading include securities and derivatives designated by the FRB, SEC and CFTC. Further a banking entity will be prohibited from investing or sponsoring certain hedge funds and private equity funds, but for certain fiduciary exemptions and de minimis investment limits, up to 3% of banks Tier1 capital. Dodd-Frank Act still purports to preserve a banking entitys vital role in the financial system like: market making/underwriting to meet reasonably expected near term demands; risk mitigating hedging activities; and investment in obligation of US government and government bodies. From bank holding companies perspective certain lex specialis regulated insurance activities within the group is also permitted. 62 Currently being in the transition phase of developing detailed rules under Dodd-Frank Act, there needs to be bright-line between proprietary trading and market making. However in spirit, the Act contains wide powers of engaging the regulators and the
60

See FSA Consultation paper 09/29 Strengthening Capital Standards 3 (FSA May 2011): Pg. 43- 54. The basic large exposure limit is 25% of firms capital resources, to withstand any counterparty credit risk. With further guidance is awaited from CEBS, certain additional risk assessment measures to be made for intra group exposures and exposures to schemes through underlying schemes and structures like CIUs and CLOs. 61 See Independent Commission on Banking (ICB), Interim Report: Consultation on reform options (ICB 12 April 2011) Annex 7- Illustration of structural reform, pg. 189-194. UK reforms are still in the form of proposals made by the ICB, which will need to be separately legislated to take effect. Also see news reported on FT.com on 4 August 2011, Stricter ring fencing for banks than feared, last accessed on 20 August 2011 at http://www.ft.com/cms/s/0/0d4554cc-bebe-11e0-a36b-00144feabdc0.html#axzz1X3ybc3Bf. For FSA regulation on large exposure see supra (n60) 62 See Mayer Brown LLP Understanding the New Financial Reform Legislation: The Dodd-Frank Wall Street Reform and Consumer Protection Act (July 2010). Dodd Frank Act Section 619 - The Volcker Rule is wide in coverage of FDIC insured banking entities, their holding companies (bank holding companies), non US bank / parent company which has US based banking entities, and even expanded to cover subsidiaries/ affiliates of the aforesaid entities. (pg. 65-71). The hedge funds/ private equity funds covered are those availing exemptions under Section 3(c)(1) and 3(c)(7) of the Investment Companies Act,1940. These exemptions were given for funds with less than 100 US beneficial owners or certain qualified purchasers. Further under Section 716 federal assistance was denied for swap entities, other than hedging of interest rate/currency swaps, in the banking entities portfolio.(pg.82-84)

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banks, for further rule making and/ or guidance of what constitutes as proprietary trading. Moreover issue arises of cross border regulatory arbitrage for non-US banks; European counterparts and shadow banking system to which these activities may be transferred reducing the competitiveness of US banking entities.63 Securitisation is one of the key offering in the shadow banking system, still braced for the impacts of the Volcker Rule. The rule of construction under (g)(2) of the said Rule expressly authorises banking entities to sell or securitize loans which is a mechanism for capital creation and distribution of risk. However there still needs clarity whether de minimis investment limits (of 3%) may crowd out other opportunities, to comply with skin in the game provisions, which may involve loss bearing tranches qua equity in the securitisation vehicles.64 It also can be argued that a de minimis may reduce the monitoring incentives of loan originating banks due to an immaterial capital exposure in securitisation portfolios. Previous ring fencing controls under Section 23A of Federal Reserve Act imposed quantitative limitations for covered transactions with a banks affiliates based on banks capital and surplus. It also regulated the terms and conditions promoting safe banking practices and prohibits purchase of low quality securities. More importantly the said regulation also contained an attribution rule to prevent the bank circumventing this said rule by engaging a non-affiliated entity to assist its affiliates. In the aftermath of Gramm-Leach- Bliley Act 1999 which led to the rise to financial conglomerates; and during the peak of the crisis, exemptions were granted by the FRB weakening the effectiveness of the provision. The view that banks were well capitalized sometimes
63

See Ryan K. Brissette, The Volcker Rules unintended consequences, (2011) 15 North Carolina Banking Institute 231-258. 64 See The American Securitization Forum vide its letter dated 10 November 2010 to FSOC has requested clarification on the Volcker rule limits for investment with affiliates and asked for a possible exemption for securitization vehicle http://www.americansecuritization.com/uploadedFiles/ASF_Volcker_Rule_Comment_Letter_111010.pdf. . Also see FSOC Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships With Hedge Funds & Private Equity Funds, January 2011, pg. 47; Accessed at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011% 20rg.pdf.

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formed the basis for justifying FRB exemptions, which proved not to be the case in rapid asset price deteriorations. Dodd-Frank Act has eliminated the flexibility for exceptions from quantitative rulings; and also widened the scope of affiliates to include hedge funds / private equity funds where banking entities have an advisory / fiduciary role, for the purposes of covered transactions. Also to strengthen the attribution rule transaction terms with non-controlling third-party funds should be on an arms-length basis. 65 The major criticism for the ideology of Volcker Rule is that it shifts risk to the shadow banking sector. Banking system depends on markets like derivatives for risk transformation, where hedge funds and other shadow banking participants are actively engaged. A build-up of risk in shadow banking systems can also affect the banking system. There is also a need for regular engagement with the regulators, in terms of market trade data and characterisation of financial transactions which may amplify the inherent incentives of market participants to circumvent financial regulations. The key factor encouraging regulatory arbitrage between US-EU regimes inter alia is the lack of harmonisation in regulatory characterisation of financial transactions.66 Further to enhance transparency and effective of quantitative and qualitative data collection, a more robust regime of corporate governance needs to be incorporated at group holding company and subsidiary company levels.67 3.1.2 SIFIs & Orderly Resolution Regime Why Lehman was allowed to fail? The answer is that all non-competitive firms should fail, not being too big to fail to be rescued at the expense of the tax payer 68. On the

65

See Saule T. Omarova, From Gramm-Leach-Bliley to Dodd-Frank: The unfulfilled promise of section 23A of the Federal Reserve Act, (2011) Volume 89 North Carolina Law Review 1683-1769 66 See generally Edward Greene and Mbabazi Kasara, The Volcker Rule and its impact on the American financial system, (2011) 5 Journal of International Banking and Financial Law 272 67 See infra section titled Corporate Governance rules 68 See Henry Paulson, Lehman Had to Fail; FinReg May Help Others: Paulson, (CNBC October 27, 2010) Accessed at

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other hand, too-big-to fail LCFIs can cause systemic ripple effects on a larger scale, because they comprise of a complex network of interconnected entities, through its cross holding structures and guarantees, and across jurisdictions.69 Two main strategies that are evolving in the US and UK; i) the SIFIs should be made resilient to failures by additional supervisory regulation and additional capital requirements; and ii) there should be a regime of orderly resolution for these entities. The regulatory objective in the context of SIFIs is not aimed at reducing the risk of failure, rather to minimise the impact of failure. It also reduces time and cost by a predetermined mechanism for relatively quicker and orderly resolution. The resolution regimes in the UK and US have similarities and dissimilarities. The proposed resolution regime tabled by HM Treasury advocates an administration regime based on whether the distressed entity is a deposit-taking bank or an investment bank or Universal bank (or LCFIs) to be; SAR, or SAR (Bank Administration), or SAR (Bank Insolvency), after taking into consideration the order of provisions of Banking Act 2009 or otherwise public interest considerations. The FSA, in the interest of financial stability may direct the administrator to formulate proposals for stability options under Banking Act 2009.70 The US regime has a similar administration regime called Orderly Liquidation Authority (OLA) which is modelled on FDIC being the receiver: for Bank holding companies; and non-bank financial companies regulated by FRB. The FDIC has been given additional powers to create a bridge financial company for non-bank or banking companies, wherein the UK it seems that bridge bank carve-outs are for deposit-taking businesses only. However the US OLA has certain departures from traditional

http://www.cnbc.com/id/39869844/Lehman_Had_to_Fail_FinReg_May_Help_Others_Paulson. 69 See supra chapter 2 70 See HM Treasury report, Special Administration regime for investment firms, (HM Treasury September 2010) ISBN 978-1-84532-773-6 PU1036. Also see Michael Raffan, Establishing resolution arrangements for investment banks: HM Treasury consultation, (2010) 3 Journal of International Banking and Financial Law 174

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insolvency procedures: where non-executive 180 days back pay and certain employee benefits are subordinated to unsecured creditors; changes in priority for debts arising under normal course business over other unsecured claims. Both UK and US regimes are proposing measures to reduce impact of failure ex ante by creating living wills for speeding the winding up procedures. Living wills can be used for structural separation of complex group structures and can make provisions for contingency funds. Living wills can facilitate pre-insolvency assessment of potential private sector LOLR each respective jurisdiction, by cross-border regulatory cooperation. However the living wills for LCFIs need legislative reform in recognising and harmonising insolvency laws under cross border insolvency regimes.71 The UK regime also has certain important proposals for recovery of client money and assets; pro-rata allocation for shortfalls on clients assets; and improving arrangements for reconciling counterparty positions.72 In the case of LCFIs, the key issue with regard to multiple jurisdictional insolvency regimes is that there are differences in insolvency laws, even within the EU regimes. The differences can arise with respect to priority claims and treatment of security interests. With respect to initiating proceedings there is EU wide harmonisation vide Article 3 of EU Regulation 1346/2000, which exhorts initiation of insolvency proceedings at the centre of main interests (COMI), and that secondary proceedings are taken up in other EU regimes for recovery of debtors assets. The law for the secondary proceedings will be law of that Member State where the proceeding, whether primary/ secondary is taking place. In the case of Alitalia Linee Aeree Italiane SpA

71

See Adam Mayle, Developments in Banking and Financial Law: 2010: II. Orderly Liquidation Authority, (2010) 30 Review of Banking & Financial Law 3 Fall 2010. Also see E. Avgouleas and C. Goodhart (n30) Living wills are recovery and resolution plans to facilitate the orderly resolution and structural separation of divisions in the event of potential default/ insolvency. 72 See HM Treasury report (n70). Also See Campbell and Moffatt, Dealing with financially distressed investment banks: the new rescue proposals, (2011) 1 Journal of International Banking and Financial Law 34

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Connock and Another v Fantozzi73 the English Courts applied English law for priority in allocation of assets in England eventhough initial proceedings were opened in Italy. There still remains EU wide harmonization with respect to; creditors automatic stay; schemes of arrangement; priority rankings for payment; and liability of responsible persons. Recognition of international insolvency through statutory laws in UK qua: Section of 426 of legislation for recognition of insolvencies of Commonwealth countries; and UNCITRAL model law on Cross border Insolvency legislated in 2006, based on the principles of international comity.74 An alternative structure can be companies structuring their COMI to be situated in UK; the English courts may sanction such winding up on the basis of sufficient connection with English jurisdiction; see Re Drax Holdings Ltd and Re DAP Holding NV. However in the case of Re Gallery Capital SA and Gallery Media Group Limited, the English court did not rule out the open ended issue of further creditor claims in a different jurisdiction. In case of non-EU debtor, where certain agreements governed by English law have been given an exclusive- jurisdiction for dispute settlement, the question arises of validity of consent by creditors to a scheme initiated at COMI of a different jurisdiction. The view can be taken that insolvency laws of the COMI jurisdiction may prevails as in automatic stay, both as matter of mandatory rule and principle of international comity.75 3.1.3 Capital adequacy regime affecting investment firms Capital adequacy regime may have direct and indirect effect on the shadow banking business model. Direct effect occurs when regulation requires minimum level of capital backing at: securitisation collateral level; securitisation portfolio level; entity-level;
73

Alitalia Linee Aeree Italiane SpA Connock and Another v Fantozzi [2011] All ER (D) 104 (Jan) (Companies Court, Chancery Division) Also see Jonathan Lawrence, Cross-jurisdiction Insolvency Proceedings, (2011) 2 Journal of International Banking and Financial Law 102 74 See EU Directorate General for Internal policies, Harmonisation of Insolvency law at EU level, 2010 PE 419.633 75 See Jo Windsor and Paul Sidle, International recognition of schemes of arrangement (2010) 9 Journal of International Banking and Financial Law 523

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holding company level; and, even economic entity/ group level. Indirect effect occurs when increased capital adequacy levels are imposed for banking entities or bank holding companies, which may dis-align incentives between the originating bank and shadow banking participant, in terms of cost-spreads and profit margins. In the UK, the EU Capital Adequacy Directive regime (CRD) covers investment firms76, bringing about the direct effect for them. In other cases when stricter capital adequacy norms are applicable to banks / credit institutions, there are indirect effects on their incentives as financial intermediaries. In the UK, as a matter of super equivalence FSA imposes a stricter regime than EU CRD2 for hybrid capital by SPV issuances, limiting it to the 15% bucket, enhancing capital loss absorbency. Moreover emergency situation convertibles with no exit options are restricted to a 50% bucket of the total hybrid capital. 77These limitations may affect certain tax advantageous structuring using indirect issuance of hybrid capital. The alternative credit structures like securitisation and mark-to-market financial securities are also impacted by revised capital adequacy norms. The EU CRD3 regime tackles risk in the trading book by: incremental risk charge (IRC) against migration risk due to down grading of ratings; and stressed V-a-R charge on a weekly basis to capture financial stress situations. There has been introduced a higher risk charge for resecuritisations; there mandates a 5% retention of net economic interest by an originator in a securitisation portfolio under Article 122a introduced under the CRD2 regime; higher risk deduction @ 1250% for unfunded support by a credit institution by itself; proper due diligence before investing; and disclosures requirements with proper
76

See FSA Consultation paper (2009) 09/29 Strengthening Capital Standards 3 issued in December 2009, Pg18-19 - Investment firms carrying on activities which are covered under MiFID (not exempted out of Article 3, generally investment firms which do not hold any client money or securities or place themselves in debt with their clients) and the recast CAD, are subject to new CRD requirements. The base requirement of capital (FSA BIPRU) is determined based on investment activity as - 50K, 125K and 730K. The ongoing capital resource requirement will be determined the on the categorization of being a full scope BIPRU firm or BIPRU limited activity firm or BIPRU limited license firm being the higher of base capital or sum of credit, market risk and fixed overhead requirements.
77

See FSA Consultation paper 09/29 (n76) pg. 22 -26

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underwriting standards. There are other provisions for: prudential valuation under fair valuation concepts; disclosure of risks under securitisation, including liquidity risk; stating of objectives for the securitisation; type of entity as a sponsor; and, break-ups of re-securitisation in the securitisation pool. The CRD3 also advocates individual capital guidance assessment on adequate financial resources of individual firms by supervisory regulator.78 Title IX of the Dodd Frank Act mandates this principle of credit risk retention or skin-in-the- game provision of 5% of assets in securitisation, but allows regulators to fix different risk retention percentages based on the nature of asset backed by the securitisation. Capital adequacy requirements at group consolidation level, reduces incentives for over leveraging. The US Dodd Frank Act (the Collins Amendment), in principle requires risk based capital and minimum leverage ratios on a consolidated basis/ group level, for bank holding companies and systemically important non-banking institutions. Sec 165(b) and (j) imposes a leverage ratio of 15-1 and higher risk based capital requirements for systemically important companies.79 The crucial question on leverage norms still remains; whether it there should imposed as a regulatory cap or rather as a trigger point for individual assessments. 3.2 PART II: Market based regulations 3.2.1 Systemically important markets - Market Infrastructure and behavioural reforms Regulators across the globe advocate a mandatory requirement of hitherto bilateral OTC derivatives, like CRT techniques which were effected through credit default swaps
78

See FSA Consultation paper (2011) 11/9 Strengthening Capital Standards 3: further consultation on CRD 3 (FSA May 2011) pg. 14-16, 18, 22, 31, 36. Pillar 3 of capital adequacy requirement also exhorts enhanced public disclosures of risk profiles to market participants. 79 See Mayer Brown LLP (n62) Dodd Frank Act Section 165 (b) and Section 171 (Pg.17-22) Also see Arthur E. Wilmarth Jr. (n51) pg. 1006-1115. This impacts capital adequacy requirements even at LCFI level; this may be seen as an improvement to the earlier norms of erstwhile SECs net capital rule computed at CSE holding company level (n 28)

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(CDS), to be traded on Central Counterparty (CCP) counters. The move involves: increasing pre and post trade transparency; multi-lateral netting of trades; better monitoring of risks and margin requirements avoiding liquidity risks for this systemically important financial market (SIFMs)80; better pricing information; and portability advantages in case of clearing member default. It also has a wider spread for standardization of derivative contracts bringing more homogeneity to financial products. There may be proposed regulatory arbitrage advantage of lower risk-weights for positions traded through CCPs as indicated in G20 Pittsburgh summit.81 There is currently a push for conducting Securities lending contracts on CCP counters which would change the cost dynamics for such trade.82 There may be other areas for regulatory arbitrage between US and EU regime in the regulation for derivative contracts, till some finality of review for EU MiFID regime. The US Regime for CCP mandatory clearing has cast its net wider than the European regime, to include commonly known market swaps, than specified underlying as in the case of EU. Also the US end-user exemption for non-financial counterparties is based on eligible contracts, a stricter regime than Europe which includes non-financial counterparties only if they exceed specified thresholds.83 EMIR proposes a mandatory regime of clearing eligible contracts of financial and nonfinancial (exceeding threshold level) counterparties through a multilateral CCP and its constituent clearing members. The multilateral system reduces counterparty risk,

mutualisation of clearing members risk, and achieves certain operational efficiencies. The positions require margining requirements to be held at the CCP level by clearing
80

BiS data indicated the notional value of CDS on June 2007 stood at $58 trillion,( reported in Deutsche Bank Research on Credit default Swaps: heading towards a more stable system issued 21 December 2009, pg.3) 81 See IOSCO, Principles for financial markets infrastructures, (2011) Technical Committee Committee on Payment and Settlement Systems. Also see FSB, OTC Derivative markets reform: Progress report on Implementation (2011) issued on 15 April 2011. 82 Reported by Sophie Baker Eurex launch reignites debate on securities lending CCP on Financial News dated 20 June 2011: Last accessed on 31 August 2011 at http://www.efinancialnews.com/story/2011-06-20/eurex-launchreignites-debate. 83 See Bates, Gleeson and Felsenthal, Regulation of OTC Derivatives markets: EU and US initiatives (2010) 10 Journal of International Banking and Financial Law 623

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member in the form of initial margins and variation margins. The CCP will be required maintain margins, backed by high quality collateral to mitigate any potential liquidity and concentration risk. Reading the EMIR together with the AIFMD may bring hedge funds, private equity funds, real estate funds and infrastructure funds within the definition of financial counterparties. The key issue is that clearing members lose their right to re-hypothecate their collateral received as margin, and technically the CCP due to segregation and portability requirements may not be able to freely re-hypothecate themselves. This will impact liquidity and increase the cost of eligible transactions.84 The risks of default / insolvency of a clearing member under CCP system has been addressed by portability mechanisms, where the failing clearing position will revert to the CCP itself based on the principle of novation or a substitute clearing member under the portability arrangements. The EMIR regime allows a CCP network to include clearing members across the globe and even CCPs outside the European Union. The challenge arises to portability when national insolvency laws may trump any predefined portability transfer of positions from the failed clearing member.85 There also remains the possibility of concentration of systemic risks due to centrality of CCP trading which can be even more dangerous than decentralised OTC trading platforms.86 There are certain behavioural aspects of market making in SIFMs that can be discussed here. From the perspective the on-going EU Sovereign crisis current, a very interesting picture arises with regard to CDS protection taken, as the case of Greece defaulting on its Sovereign debt. The analysis showed that European firms held the debt exposure
84

See Tariq Zafar Rasheed, Rings to bind them all: central counterparties and collateralization issues, (2011) 6 Journal of Banking and Financial Law 331. 85 See Bas Zebregs, Guaranteed Portability under EMIR?, (2011) 5 Journal of International Banking and Financial Law 276. Also see infra chapter 4 section titled Bankruptcy remoteness & insolvency remoteness in financing structures and (n97) 86 See Duffie and Zhu, Does a Central Clearing Counterparty Reduce Counterparty Risk?, (2010) Graduate School of Business, Stanford University. Examples of clearing-house failures include those of Caisse de Liquidation, Paris, (1974), the Kuala Lumpur Commodity Clearing House (1983), and the Hong Kong Futures Guarantee Corporation (1987) pg.12

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significantly, whereas American firms sold substantially default protection against Greeces failure without necessarily holding themselves an underlying long position. This begs the question whether such transactions represent more speculative bets rather than a hedging strategy.87 In September 2008 following the Lehman crisis many jurisdictions banned short selling in financial sector as an emergency measure to prevent speculative driving down of market prices. Despite the apparent speculative trend which is associated with short-selling, it facilitates re-pricing strategies for overvalued securities, market liquidity and hedging strategies. Naked short-selling without any underlying long position, contributes to added settlement risk. The current regime in US and EU is for additional disclosure regime than an outright ban on short selling; like SEC SHO regulation requirement for broker-dealer marking positions as long or short or short exempt. There are rules which however provide market-maker exemptions for equity options and derivatives with the objective of ensuring liquidity in markets, leading to incomplete information on total short selling interest. FSA and SEC consultations have further advocated notification of short sale positions at threshold of 0.25% - 0.50% of issuers outstanding capital. An additional precautionary circuitbreaker is an added check to cease trade temporarily, to arrest rapid corrections. Complementarily once a specified circuit breaker is triggered, an alternative uptick price rule allows short sale at par higher than national best bid. Other deterrents are penalties for insider trading and market manipulation for speculative traders.88

87

Reported by Street light, Betting on the PIGS on 6 June 2011: Last accessed on 30 August 2011 at http://streetlightblog.blogspot.com/2011/06/betting-on-pigs.html. The analysis was based on Bank of International Settlement - Statistical Annex, June 2011. 88 See Emilios Avgouleas, A new framework for global regulation of short sales: Why prohibition is inefficient and disclosure insufficient, (2010) Volume 15 Issue 2 Stanford Journal of Law, Business & Finance Spring 2010 376425. Also see Annette L. Nazareth ,The SECs New Short Sale Rule: Implications and Ambiguities posted on 14 March 2010 at Harvard law School Forum on Corporate Governance and Financial Regulations; Last accessed on 15 September 2011 at http://blogs.law.harvard.edu/corpgov/2010/03/14/the-sec%e2%80%99s-new-short-sale-ruleimplications-and-ambiguities/. For penalties in market manipulation relevant legal provisions are given in EU Market Abuse Directive, 2003 and SECs Sec 10 (b) and 20 (a) read along with SEC rule 10b-5.

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3.3 PART III: Broad basing regulatory boundaries 3.3.1 Information Asymmetry mitigating factor to weaknesses in market infrastructure The SEC reforms under safe harbour provisions of Sec 144A and Regulation D, hitherto used by non-US issuers, has been amended to require public-issues-like disclosures for private securitisation issues,. The SEC regulation ABS has introduced loan-level information to be provided in a securitisation pool. These cashflows under waterfalls should be provided and capable of being stress tested. Moreover the skinin-the-game provisions for risk retention both under SEC and EU CRD Article 122a, enhances the level of due diligence function. Under Regulation ABS the originator may be liable to buy-back pool assets, if there is a violation of representation and warranties. This regulation certainly goes ahead to ensuring that the monitoring incentives of the loan originators are preserved. Further under Rule 17g-5, to promote unsolicited rating, the regime requires the information provided to the rating agencies for the securitisation transaction should also be made accessible to other rating agencies on a secured website. This may counter the conflict-of-interest in the issuer-payer models for rating assignments. The reliance on the rating agencies have been reduced in respect of changing criteria based on rating, for shelf registration of prospectus for issue.89 3.3.2 Secondary market participants like Hedge funds & Private Equity It is debated whether hedge banks are a part of shadow banks, while in certain respects their asset management functions are vital for market making for certain credit
89

See Clifford Chance, New Landscapes: Practical evaluations of new regulations impacting structured debt transactions, (2010) Clifford Chance Publications. Also see supra added information requirements for securitization under EU CRD rules and see (n78)

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derivatives. The Dodd Frank Act has attempted to bring out of the shadows, certain investment advisors by eliminating exemptions under private investment advisor; and by redefining accredited investor availing exemption under Regulation D of the SEC Act, which may impact non US funds which may advertise to a select few, without being registered as Investment advisors. Being an SEC registered investment advisor, they cannot charge a percentage share of gains on the transaction further reducing incentives for such market players. Moreover the Volcker rule has curtailed access of banks to sponsor private equity, by introducing its de minimis limits.90 The EU AIFMD regime regulates these firms by imposing minimum own fund requirements; EU based regulated depository for safeguarding client assets; set procedures for valuation independence; remuneration code; and restrictions on national private placement route for marketing to professional investors. 91 Further Non EU AIF has restrictions on marketing or availing an EU passport and some additional information exchange requirements with the member state supervisor which may raise the question whether the EU AIFMD is being protectionist from a market access point of view.92 3.3.3 Corporate governance rules Corporate governance code is applicable for listed entities in a blanket format across sectors. It requires close monitoring at firms shareholder monitoring level and listed exchange level, and usually operates like soft law. There could be merit in devising corporate governance related disclosure more sector specific (e.g. financial sector), especially with respect to risk management. In the UK, Sir David Walkers
90

See A. Greenough, J. Hulburt and N. Holman, How Dodd Frank and AIFM will rein in private equity, (2010) Volume 29 Issue 9 International Financial Law Review Nov 2010 43 91 See Margaret Chamberlin, The AIFMD: the dawn of a new era, (2011) 2 Journal of International Banking and Financial law 59. Also see Andrew Baker, Hedge funds are not shadow banks reported on 15 May 2011 on FT.com. Last accessed on 15 September 2011 http://www.ft.com/cms/s/0/611b8e26-7d8d-11e0-b41800144feabdc0.html#axzz1XDYAHkFw. 92 See Burdett and Dockrell, AIFMD Directive: Competing directives, (2010) Volume 29 Issue 8 International Financial Law Review 39

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recommendations in 2009 for corporate governance reform were mainly focussed on risk governance and disclosure of high end compensation. He proposed a new stewardship code enhancing the shareholder-board engagement, by way creating an official code for best practices for shareholder-board communication. FSA will be more intrusive in assessing the risk oversight practices of regulated persons, and may be involved in appointment of independent directors (NEDs) in such regulated financial institutions. Sir Walker also identified board of directors primarily focussed on risk management and formulating risk management strategies. On an executive level a Chief Risk Officer (CRO) would be responsible for its implementation. The remuneration code should focus on long term reward structure rather than short term and with also reporting on different high end-low end remuneration ratios.93 Title IX of the Dodd Frank Act on Corporate governance lays down the framework of shareholder approval for pay structure; pay arrangements of executives in a merger or similar arrangement; and golden parachute matters. There has been mandated additional disclosure on the compensation ratio between CEO and all employees; and permission for employees or directors to purchase company equity price hedges. There may be a claw back of incentives for misstatements for a back period up to three years.94 It may do well to expand corporate-governance-like-principles in corporate law or financial regulations to cover unlisted entities, especially private issuers of financial securities.

93

See Roger Baker, The new governance of UK finance: Implementing the Walker Review, (2010) 5 Journal of International Banking and Financial Law 298. 94 See Mayer Brown LLP (n 62) - Dodd Frank Act Title IX (pg.111-112)

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3.4 Concluding remarks Global reforms reflected the debate on issues which arose from lessons-from-the-crisis, for reducing the moral hazard for supporting failing SIFIs. The emphasis on structural reforms where to separate risky business from deposit-insured banks, may severely impact funding position of certain shadow bank participants. The reforms are envisaged differently in US and Europe which may lead to exploiting regulatory arbitrage or in contrast promote healthy regulatory competition95. The non-structural/ behavioural reforms like increased capital or market infrastructure reforms will reduce systemic risk, however their impacts on cost and capability for being monitored needs to be seen. Dodd-Frank Act which purports wide ranging reform is still merely a framework which needs detailed rules to be framed and lengthy implementation periods. Moreover the other important issue for counterparty risk contagion lies with orderly and quick resolution regime for LCFIs, which still needs global co-ordination for recognition of cross border insolvency and protection of client assets. On the positive side, the reforms have attempted to cast its net wide to regulate the shadow banking participants, albeit in a fragmented manner.

95

See infra C. Goodhart and R. Lastra (n136)

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Chapter 4- Motivations for Shadow Banking Financing Structures This chapter focuses on motivations for financial innovation in creating shadow banking financing structures in the light of bankruptcy provisions, taxation, applicable law and liabilities under domestic laws, including securities law. There is also a brief discussion on conflict-of-interest regime while selling financial products. 4.1 Bankruptcy remoteness & insolvency remoteness in financing structures One of the key features of financial structuring is to use various strategies for enabling bankruptcy remoteness and insolvency remoteness. Insolvency remoteness aims to keep the entity outside the provisions of insolvency, whereas bankruptcy remoteness achieves a form of immunity from bankruptcy procedures, in other words, bankruptcy would not cause a re-characterisation of the position of the lender/creditor. The structuring for bankruptcy / insolvency remoteness can be conceived at financial product level or entity level. Bankruptcy remoteness plays an important part in formulating the strategy for financial structuring. The commonly used structures, like SIVs and CDO conduits, have mismatched and matched cashflows pools. Short term notes issued against such pools are rated based on: their cashflow strengths; higher quality/highly rated assets held; and more importantly, bankruptcy remoteness of the asset portfolio.96 Counterparties of repo and certain derivatives are given super-priority like treatment over other creditors shielding them from an automatic stay under Chapter 11 bankruptcy protection, making them bankruptcy remote. Repos bankruptcy remoteness was based on the premise that these were financial accommodations as distinguished

96

See generally David Eskew, SIVs, CDOs and Structured Products in Distress: Cross-Border and Other Issues for Lenders and Investors, (Kaye Scholer LLP contribution in The Americas Restructuring and Insolvency Guide 2008/2009 (Globe White Page))

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from executory contracts. Repo collateral is protected from automatic stay and the repo counterparties can off-set/ net-off obligations invoking ipso facto clauses under US Bankruptcy code. Derivatives on the other hand are like executory contracts, but in bankruptcy the counterparty can terminate based on ipso facto clauses. The debtor right to assume/reject leading to cherry picking of good contracts from bad contracts, is only precluded under master agreement obligations. The supporting argument for derivatives safe harbour provisions is to reduce adverse systemic impacts due to potential liabilities of derivatives exposures at the time of insolvency. The irony remains that, rescue of Bear Sterns and AIG was done fearing systemic market impacts on termination of derivative exposures. 97 Similar privileges are given in the EU regime for financial collateral for close-out netting and title transfer collateral (EU Financial Collateral Directive 2002) with reduced formal requirements for perfection of title; enforcement irrespective of insolvency proceedings (Article 4(5) and Article 8 of the Directive); and appropriation at fair value as agreed by parties protecting interest of the collateral giver. Also in the context of CCP trading, collateral traded at a recognised clearing house, may be able to dis-apply regular insolvency proceeding concerning property disposition (Part VII of UK Companies Act, 1989).98 These special privileges may have reduced risk pricing and monitoring incentives, whilst creating an explosion in credit supply. The Lehman and Drexel Burnham cases indicate corporate structure enabling insolvency remoteness. The brokerage entities were not involved in the bankruptcy

97

See David A. Skeel Jr., Bankruptcy Boundary Games (2009) Research paper 09-25 Institute for Law and Economics [Wharton Law School and University of Pennsylvania]. Also see same author, Jackson, and Thomas, "Transaction Consistency and the New Finance in Bankruptcy" (2011) Scholarship at Penn Law Paper 355. Also see supra FCIC (n57) 98 See Gulenay Rusen, Financial Collateral Arrangements, (2007) Volume2 Issue 4 Journal of International Commercial Law and Technology 250-258. Also see D. Barwise, J. Reynolds and T. Yang, Not yet clear: Issues surrounding central counterparty clearing, (2010) 10 Journal of International Banking and Financial Law 598.

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filings under USC Chapter 11 taking advantage of exclusions under Bankruptcy code. Moreover there are safe harbour provisions for market settlement activities by middlemen shielding them from draconian fraudulent and preferential conveyance carve outs under bankruptcy regimes. The legal certainty of these safe harbour provisions are subjective; in the case of Enrons market purchases of its stock and commercial papers prior to bankruptcy filings, were not protected from this harbour defence. 99 Another aspect of bankruptcy remoteness of an entity lies in the true sale characterisation of receivables securitized to SPVs by original lenders. The terms of the sale of such receivables are usually non-recourse to the original lender, unlike a mere assignment even though the originator may be involved in a limited administrative capacity. An accounting consolidation of the SPV under IFRS rules, due to the originator maintaining minority equity retention in the SPV should prima facie not affect its bankruptcy remoteness; however any loss at SPV level will impact debt-equity leverages at originators consolidated balance sheet level.100 These structures may be remote from bankruptcy of the original lender/ sponsor, but face an insolvency quandary when put to the test of cashflow insolvency or balance sheet insolvency. Considering the credit risk tiering/tranching, in such events both senior creditors and junior creditors will be subject to pari passu albeit within their relevant classes of seniority. In the BNY Corporate Trustee Services Ltd v Eurosail case101 a higher test was proposed for balance sheet insolvency u/s 123(2) of UK safe

99

See David A. Skeel Jr., Jackson, and Thomas (n97) Legislation may have contemplated that troubled brokerages would be liquidated in Chapter 7, and that the liquidation would be coordinated with the insurance scheme for brokerage customers established by the Securities Investor Protection Act of 1970 100 See Philip Wood, Law and Practice of International Finance, (1st Edition University Edition Sweet & Maxwell, London 2008) pg.470 101 BNY Corporate Trustee Services Ltd v Eurosail- Uk 2007- 3bl plc and others [2011] EWCA Civ 227. See Freshfields Bruckhaus Deringer LLP, A Commercial approach to balance sheet insolvency test, (Case Briefing March 2011). The case of insolvency arose when a hedging transaction was terminated following Lehman bankruptcy and accounting of the effect lead to excess of liabilities over assets. However the Court required a commercial common sense approach taking into account the long term prospects than a near term accounting excess of liabilities over assets. In this case there was evidence for ability to pay off its debts based on future prospects.

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Insolvency Act, taking into account the future realisability of assets rather than an immediate accounting excess of liabilities over assets. In this case PECO (post enforcement call options) were employed in a limited recourse structure where the note holders had a claim only on the assets of the entity, any residual claim was to be transferred to a separate entity, making the issuer bankruptcy remote. There may be further confusion added during potential insolvency events due to fiduciary position of directors liability for failing to file for insolvency in a timely manner, adding more fuel to the fire.102 Structuring can be done at an entity level to facilitate flexibility to lenders to negotiate a restructuring before going into administration. In a recent Paris Supreme Courts ruling in the case of Heart of La Dfense SAS and Srl Dame (Luxembourg Hold Co.) extended its safeguard regime (pre-insolvency safeguard) to a Paris registered entity and its Luxembourg parent , on the basis on EC Regulation 1346/2000 COMI rules, much to the disappointment of lenders negotiating a restructuring deal. In the wake of this decision certain double Luxco LBO structuring has been employed by taking advantage of Luxembourg law. The double Luxco structure requires a Luxembourg Hold Co (Lux 2) of the Hold Co (Lux 1) of the Paris entity, to pledge its shares in Lux 1 in favour of lenders in Lux 2. This enables the lenders to take over control of the Paris entity despite the safeguard procedures in Paris; legal status of this structure is yet to be tested.103 Other form of alternative for speedy administration is the use of pre-pack administration with the creditors for sale of realisable assets while continuing business in under the administration regime.104

102

See Philip Wood (n100) pg.69 -The English jurisdiction for wrongful trading under Section 214 and 215 of the English Insolvency Act 1986 103 See Erwan Hricotte, The use of double luxco structures in French LBO, (2011) 7 Journal of International Banking and Financial Law 432 104 See Jochelle Mendonca and Nick Brown, Jackson Hewitt files for pre-packaged bankruptcy (Reuters 24 May 2011) http://www.reuters.com/article/2011/05/24/us-jacksonhewitt-idUSTRE74N4HP20110524; Also see DKLL

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Bankruptcy remoteness under contractual structuring and/or insolvency law can be envisaged with the usage of set off provisions and flip provisions. Set off allows a creditor at the advent of insolvency, to set off monetary obligations against any receivables, creating a characteristic super-priority over other creditors. This creates distortion of protection, for a creditor with seniority in claim versus a creditor with a set-off option. The principle underlying the right to set off is that there should be mutuality in cross claims between same parties and in respect of the same rights/ interests, existing before the time of going into insolvency.105The Lehman vs. Caylon106 case affirmed the rights for set-off under New York law not to be affected by the Chapter 11 bankruptcy filing; and, in Enterprise v Mcfadden107 the Court clarified that set-off is triggered by notice of administration under UK Insolvency laws. On the other hand, flip provisions intends to create a priority in waterfalls, preoccurrence of an event of default including insolvency. There have been conflicting judgements in the US and UK, in the Perpetual Trustee Company Limited v BNY Corporate Trustee Services case. In the UK the Court upheld the validity of flip provision, as a special case without applying the established anti-deprivation principle. In the US however, there was held to be a contravention of ipso facto violation of US bankruptcy law prohibiting variation of contractual rights at the commencement of insolvency, as there was a close connection between the triggering of flip provision and the event of insolvency. This can lead to strategic structuring by

Solicitors v HMRC [2007] EWHC 2067 where the Court gave sanction to a pre-pack despite dissent by HMRC (creditor) on the basis that this was the best position for both DKLL, its employers and HMRC (creditor) themselves.
105

See Ekaterina Sjostrand, The troubled waters of insolvency set-off: mutuality, the pari passu principle and other considerations, (2010) 5 Journal of International Banking and Financial Law 282 106 Lehman Brothers Commodity Services Inc v Crdit Agricole Corporate and Investment Bank (formerly Caylon) [2011] EWHC 1390 (Comm) 107 See Enterprise v McFadden [2009] EWHC 3222 (TCC)

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subsidiarisation in a UK/ European subsidiary to take advantage of the judgement in Perpetual Trustee case.108 4.2 Cross border tax structuring The motivation for a tax beneficial structure brings about cross-border aspects because tax planning majorly involves offshore entities. We will discuss the same by examining tax related issues in certain structures. As per the UK Taxation of Securitisation Companies Regulation, 2006 taxation of securitisation companies like SIV and other conduits were allowed to obtain tax neutrality, subject to cash pay-out in 18 months. This was to reduce incentives to hoard cash in offshore jurisdictions. Even to reduce fluctuations in IFRS based accounting, they were allowed to use UK GAAP accounting as existed in 2004.109 Characterisation of withholding taxes can impact the cashflows position of these structures. As in the case of sub-participations where there is no actual transfer of title, the original lender still remains the beneficial owner of receipts from the underlying loan and the sub-participant may still be liable to withholding tax in the UK. Alternatively if the sub-participant in a non-tax treaty jurisdiction, uses an intermediate situated in a tax treaty jurisdiction, it may still be considered as the beneficial owner based on the international fiscal meaning attributed to the same, as interpreted in Indofood International Finance Ltd v JP Morgan Chase Bank NA London Branch. On the other hand, where residual payments are not clearly distinguishable as interest or principal or even business profits, a limited recourse back-to-back funding may be characterised as payment as interest by a UK bank in an ordinary course, not subject

108

Perpetual Trustee Company Limited v BNY Corporate Trustee Services [2009] EWCA Civ 1160 See Clifford Chance, New landscapes: Practical evaluations of new regulations impacting structured debt transactions (London June 2011) 109 See Donohue, Blakemore and Punja,Sleeping Giants: insurance alchemy and insurance special purpose vehicles, (2011) 3 Journal of International Banking and Financial Law 145

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to withholding tax. However withholding tax provisions are machinery provisions and payer bank will analyse the transaction closely.110 The US HIRE Act 2010 imposes withholding taxes on all dividend equivalent payments including the hitherto exempt equity swaps. The characterisation of the payment in the nature of portfolio interest can earn an exemption from withholding tax. The HIRE Act also introduces the FATCA regime where payments made to foreign financial and non-financial institutions are subject to 30% withholding tax, unless it enters into an agreement with the IRS for information exchange. The legislative intention is to prevent US taxpayers being shielded by foreign institutions.111 4.3 Applicable law or Governing law Cross border financial deals encounter vagaries in interpretation of legal issues due to choice of governing law of a different jurisdiction from parties. The legal validity of a deal structure may differ based on choice of law or choice of jurisdiction, including exclusive jurisdiction choices. Regulatory arbitrage may often form the motivation for such choice of law and/or jurisdiction. In Haugesund Kommune and Narvik Kommune v Depfa ACS Bank
112

the borrower

party borrowed money to invest in swaps, later on claimed the contract void being incapacity of borrowing party ultra vires to public policy. The contract governed by English law, where restitution was ordered based on the principles of unjust enrichment in line with English law construction, and that was not against intention of public policy. This was a relief to the lending community as a reassurance of English legal status supporting restitution of international loans advanced. It is worth mentioning two other cases Depfa Bank & anor v Provincia di Pis and Berliner
110

See Adam Blakemore, Sub-participations, taxation, and the mitigation of lender credit risk, (2011) 6 Journal of International Banking and Financial Law 349 111 See Ashurst LLP, US taxation of non-US investors in securitisation transactions, Chapter 4 The International Comparative Legal Guide: Securitisation 2011. 112 Haugesund Kommune and Narvik Kommune v Depfa ACS Bank [2010] EWCA Civ 579

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Verkehrsbetriebe (BVG) Anstalt des Offentlichen Rechts ('Berliner') v JP Morgan Chase Bank NA & another, where the parties tried to avoid the English jurisdiction chosen by the parties in agreement, in favour of their national courts and challenged the jurisdiction of the English courts on the basis of Article 22(2) of the Brussels Regulation, stating that proceedings had as their object the validity of decisions of its organs. However the English court rejected the argument on the basis of connecting factors which favoured the English jurisdiction.113 Rome I regulation unifying conflict of law for EU regime, upholds the principle of parties autonomy of choice of law. If the question is raised regarding governing law applicable to an assignment of debt receivables by the lending bank, and the relationship of the assignee to the debtor, guidance is given under Article 14. The said article specifies the law underlying the original debt would determine the validity of assignment and the title of the assignee to the original debt receivable. However the generality of the provision of Article 4.2 of the said regulation, may allot a third country law if there are connecting factors to the underlying debt contract. In the case of Raiffeisen Zentralbank Osterreich AG v Five Star Trading LLC, the issue of proprietary interest in the subject matter underlying the original debt contract was raised. This debate attempted to open a new area concerning the scope of governing law under Article 12 of the said regulation in the context of residual proprietary rights of the assigned property to the world as a whole. The judgement held the view that the original debtor knowingly enters into the contract creating a legitimate expectation under the contract for the parties. Hence there remained no questions of unallocated residual proprietary rights concerning the assignment. This judgement brings simplicity in

113

See Strong and Millington-Jones, ISDA Master Agreement survives challenges to the parties' choice of English jurisdiction (2010) 7 Journal of International banking and Financial Law 431

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legitimate expectation especially in the case of an assignment of receivables, say under a securitisation.114 Its worthy to mention here, the above mentioned Perpetual Trustee Company Limited case, where the impact of a choice of governing law and its interaction with flip provisions may have different consequences in US and UK jurisdictions.115 4.4 Liabilities: Fiduciary liability; Tort law; Conflict of Interest; and Risky decision takers liabilities As the dust settles from the storm of the crisis, the major remaining question is who bears the liability for the losses suffered. In the case of a security for which a prospectus has been issued, the liability to the issuer majorly has two angles: i) the place or jurisdiction where the claim should be made; and ii) scope of liabilities that can arise. Under EU conflicts-of-law, in case any tortuous/ non-contractual liability for negligence or misrepresentation should arise, such claim should be made at the place where the direct damage has occurred (Article 4 of Rome II). The ECJ has decided in Kronhofer v Maier that financial losses on an investment should be claimed in the country where the investment account is held. However in transnational offering claims could arise from multiple jurisdictions where client hold their investment account. In the case of statutory liability under national securities law, extraterritoriality will depend on the transactional test as decided in the recent US Supreme Court Morrison vs. National Bank of Australia rather than a conducts and effects test. However generally the issuer will be sued in the country in which it is situated. Article 14 of Rome II provides

114

See Joanna Perkins, Proprietary issues arising from the assignment of debts: a new rule?, (2010) 6 Journal of International Banking and Financial Law 333 115 See supra section Bankruptcy remoteness & insolvency remoteness in financing structures (n108)

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the freedom for choice of law for non-contractual/ tortious claims, where the clause is usually specifically mentioned in the ISDA and LMA standard agreements.116 The scope of statutory liability for the issuer includes any misleading information or omission of stating information. The new regime under FSMA 102A (3) covers a wide range of securities for periodic information requirements. However under the FSMA Section 90A safe harbour provision does allow to define the scope by the issuer to a specific liability and assume responsibility to that effect. However there are exceptions to the said safe harbour provision which preserves the responsibility threshold for a person for a particular purpose.117 The liability regime for derivative contracts has certain specific issues which arise with such contracts. Derivative contracts are often zero sum games analogical to bets. Depending on the public policy of the jurisdiction of the claim, one needs to analyse the validity of such contracts. In certain regimes especially in Germany, it may mandate by law that there should be an equal chance of winning or the differential odds should be clearly mentioned. Depending on the valuation models and probabilities of assumptions this can raise the bar for disclosure requirements for derivative contracts.118 In UK the law governing disclosure requirements depends on the nature of contract and defined legal relationships. Usually misrepresentation for securities may not have a high threshold of uberimmae fidei as in insurance contracts. In the case of Northshore Ventures Limited vs. Anstead Holdings Inc and others, in the context of guarantee

contracts, the scope of misrepresentation had been widened to unusual features a creditor may have to disclose other than the contract, if it can be material to the

116

See Pamela Kiesselbach, Prospectus liability: which law applies under Rome II?, (2011) 4 Journal of International Banking and Financial Law 195. Also see the same author, Financial transactions in the crossfire of Rome II, (2011) 1 Journal of International Banking and Financial Law 25. 117 See Palmer and Roberts, Extension of the statutory regime for issuer liability, (2010) 11 Journal of International Banking and Financial Law 682.
118

See Julian Roberts, Financial derivatives: investment or bets?, (2011) 6 Journal of International Banking and Financial Law 315.

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guarantor. However there may be no liability to disclose what the guarantor would reasonably be expected to know.119 In a legal relationship as an advisor or a fiduciary in UK, liability for misselling is based on disclosure requirements as per the suitability rule and the best interests rule. The FSA Conduct of Business Code (COBS) 9 prescribes a suitability test to assess whether the client is willing and able to take a particular risk. Moreover as a professional firm carrying on investment business, as per COBS 2.2 the best interest rule requires ensuring the client be reasonably aware of the risks. In the US, depending on their function investment advisors and broker-dealers will be governed by Investment Act 1940 and Securities Act 1933 (Securities Exchange Act 1934) respectively. The US suitability rule has a higher threshold than UK best interest rule for selling investment securities.120 In the Springwell Navigation Corporation vs. JP Morgan Chase Bank and others, in the context of misselling of derivatives, the issue of an exclusion of liability was analysed. In this case, the non-reliance of representations was not considered as an exclusion clause in violation to Unfair Contract Terms Act 1977, because it was construed as contractual freedom of the parties of equal bargaining power, to decide how to conduct themselves in the transaction. However this position will depend on type of transaction and parties involved.121 At this juncture it is relevant to raise the issue of conflict-of-interest in the much publicised Goldman Sachs case, which changes liabilities of parties selling financial products. The claim of securities fraud under Securities Exchange Act 1934 was made. The issue majorly surrounded the question, whether there is fiduciary relationship in the case of marketing to sophisticated investors. If there was an element of fiduciary

119

See Paul Sinclair, Guarantees: what need to be disclosed?, (2010) 9 Journal of International Banking and Financial Law 534 120 See David Mcllroy, Financial products: selling pigs in pokes?, (2011) 3 Journal of International Banking and Financial Law 132 121 See Tak Matsuda, Contractual estoppel: Springwell Navigation Corporation vs. JP Morgan Chase Bank (2011) 43 Journal of International Banking and Financial Law 227

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liability it could extend a level of loyalty to the customer requiring informing the customer of any risk that can materially affect him. In this case, Goldman Sachs was effectively involved in selling credit protection for the hedge fund Paulson & Co. whilst selling a reverse position to some European customers, in Abacus CDOs allegedly knowing them to fail. The US Securities law earlier did not require fiduciary liability implying loyalty to the customer. It however required full disclosure and prevention of fraud. The underwriter or dealer acts as a principal in an arms-length transaction with knowledgeable sophisticated investors. Sec 621 of the Dodd-Frank Act now prohibits underwriters, placement agents, initial purchasers, and sponsors including their affiliates and subsidiaries, from entering into a materially conflicting securitisation deal for a period of one year from the closing date of the sale.122 Lastly, the common law in UK has been long established of claw back of profits earned in good faith in a breach of fiduciary duty and holds it as a constructive trust. The US SEC has recently tried to use claw back provision under Sarbanes Oxley Act 2002, to claw back the earnings due to inflated accounting; even though the concerned person was not involved in the fracas. This tool if deployed can act as a deterrent for risky decision makers.123 4.5 Concluding remarks Despite the significant reforms post-crisis, areas like bankruptcy law, taxation laws, and conflicts-of-law regimes need more harmonisation internationally to tackle cross border structures of the shadow bank systems. This would enhance legal certainty of the contracts; clarity on liabilities for risky decision takers; and avoid multiple jurisdiction claims for securities fraud. The most important reform is with regard to conflicts-ofinterest regimes in securitisation deals, following the SEC v Goldman debacle.
122 123

See Andrew F. Tuch (n35). Also see supra (n88) on liabilities under securities law See Joanna Chung Clawback marks tougher SEC stance, (Financial Times 28 July 2009) Last accessed on 5 September 2011 http://www.ft.com/cms/s/0/bca3a520-7b97-11de-9772-00144feabdc0.html#axzz1XrdScOVj.

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Chapter 5 Regulatory Alternatives When formulating regulatory strategies alternatives used are in the form of structural and behavioural regulations. Modern theories in financial regulation seem to advocate a public-private participation in setting regulation. The chapter further discusses the regulatory borders that arise in a globalized financial system concluding that a function- based approach may be better than an institution-based approach. 5.1 Financial System: Market economy and Business Models The regulatory framework for shadow banking system should be conceptualised considering them as an important sub-system in the wider financial system. The financial system is a hot-pot of conflicting incentives: public duty of banks and private profitability of shadow banks. Hence viewing the financial system as a market economy could be unpredictable, given the conflicting incentives of level playing market participants.124 Regulators are often swayed between fire-fighting and blissful lull dictated by these conflicting viewpoints. The financial system should be viewed as a life-essential system where market economy is a sub-system. Market-based financial systems are dictated by the views of its participants, banks and shadow banks. Banks competing with shadow banks in this market-based system can carve their area of specialisation complementary to their public duty function. However there creates a blur between the two participants when they are both led by the same incentive of private profitability. On the other hand, shadow banks private profit motives should be kept in check, by proper pricing of risks in their risk-reward business models. In fact the emerging idea three years after the crisis is that, the regulators went

124

See Donald C. Langevoort, Global Securities Regulation after the financial crisis, (2010) 13(3) Journal of International Economic and Trade Law 799-815, Section III on Greenspan Philosophy. Self-interest is not the same as having different objectives of level playing market participants.

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completely wrong while validating risk-pricing125 of the EVA business model of shadow banking system. The economic check-points like leverage; liquidity; and capital requirement, need to be developed based on a sustainable risk-reward business model for shadow banking system. For example, the spreads/haircuts for repo trading needed to be validated from the point of view of sustainability in extreme stress situations.126 SIFMs should have a system of monitoring market stability and their systemic impacts on the overall financial stability. 127 Financial stability is achieved when there is a stable relationship between SIFIs and SIFMs. 5.2 Self-Regulation vs. Regulatory Intervention Self-regulation and regulatory intervention are complementary and not substitutes. The globalised financial system has created hierarchy in regulatory authorities, legal and regulatory sources and enforcement mechanisms. Public-private governance structure is the extant system which has decentralised accountabilities and fragmented legal/ regulatory concepts. Regulatory arbitrage has definitely thrived in this environment. Self-regulation in its simplistic form is a behavioural regulation where the good sense of subjects decides what is good for them albeit with some guidelines. This assumes that there is reasonable level of comprehension of the guidelines and regulatory mandate. A variation of self-regulation is market-based standard setting. This is when market participants negotiate among themselves to arrive at consensus based, standardized system backed by contractual systems, for their own larger public interests. There are associations like Loan Market Association /International Swaps and Derivatives Association, were the regulated themselves are stakeholders and they mutually abide by

125 126

See supra Sandra C. Kriegars speech (n 59). See Gorton and Metrick (n19).The mandate of Dodd-Frank established the Office of Financial Research (OFR) and in UK similar role will be undertaken by Financial Conduct Authority (FCA) 127 See FSB market watch on ETFs (n 132) as a part of its systemic risk assessment and CDS notional value of 58 trillion (n80) Also See infra C. Goodhart and R. Lastra (n136)

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market practices. Over time these have developed into hard law and consulted by local/global regulators as market standards.128 Public-sector involvement in setting regulation arises where self-regulation fails. The principle for this kind of governance structure is public interest. It is when public interest conflicts with self-interest/groups interest, that public authorities step in. This can be done in the form of behavioural and/or structural reforms. For example market infrastructure reforms for OTC derivatives trading through CCP, can be structural in terms of market infrastructure restructuring and behavioural if new codes of conduct are introduced for CCP trading. The Basel/EU CRD regime of capital adequacy is based on self-assessment therefore is behavioural/ prudential, and its implementation based on soft law. Regulators may choose to introduce a principles-based or rules-based regime or a combination of both. In either case participants may liberally interpret the principles and/or rules, based on behavioural thinking and ethical standards, unless for intervention by regulators prompting discretion be used in spirit of the rules. This modern form of governance can be called a public-private governance model.129 5.3 Functional Regulation vs. Institutional Charter Functional perspective of regulation is based on the ideology that functions are more stable than institutions; the institutional charter130 of market players are constantly changing or being substituted. Various institutions like banks, insurance providers, and asset managers contribute to a host of functions which comprises the financial system: provide payments systems; access to credit systems; allocation of resources across geographical boundaries and industries; risk management; and, distribution of price and
128

See David Rouch, Self-regulation is dead: long live self-regulation, (2010) Law and Financial Markets Review March 2010 102-122 129 See supra David Rouch (n128). Also see IRIS H-Y Chiu, (2010) Law and Financial Markets Review March 2010 170-188; A paradigm change in the participation of public-private governance is the modern form of regulation. Market associations form market standards. Gatekeeper like auditors and rating agencies play a dual role: delegated governance on behalf of Governments, which is a diminishing role after the crisis; and market certification on behalf of market based standard setters to increase marketability of their products. 130 See supra chapter 2 Goldman Sachs and Morgan Stanley convert from investment banks to FRB regulated bank holding companies.

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specialised information. If achievable, an efficient functional regulation with proper information systems and lower transaction costs can reduce the relative importance of financial intermediaries. This la Arrow-Debreu equilibrium is more a theoretical proposition. Therefore the reality is that financial innovation and shift in institutional structure will constantly redefine the border parameters of functions in the financial system.131 The positive side of function-based regulation is that it reduces regulatory arbitrage and rent seeking behaviour. Functional perspective of regulation supports enhancing the stability and cost-efficiency on a functional economic model. Regulation of SIFMs can be considered as an extension of this function-based regulation and is some ways may be more effective than too-big-to-fail SIFI regime.132 However in certain bank-based systems and emerging economies, an institutional charter may be more relevant due to competition issues like entry barriers, higher government involvement in financial intermediation, strict controls over foreign currency and capital flows.133 5.4 Regulatory Borders and Regulatory Co-operation The biggest challenge in regulating SIFMs lies in the fact that, SIFMs like SIFIs are globally interconnected and are subject to web of domestic laws, global regulatory laws, contractual laws and market based conduct standards. Global regulatory norms in banking (Basel accord) and taxation (OECD and UN model) are still soft laws. This

131

See Robert C. Merton, A functional perspective of financial intermediation,(1995) Vol. 24, No. 2 Financial Management Summer 1995, pages 23-41. Functional perspective is broader than financial product regulation; financial products by means of financial innovation constantly redefine the borders of the functional system, regulators need to exercise functional oversight over financial intermediaries activities. 132 Institution-based regulation can usually be circumvented by restructuring institutions (SIFI based regulation on size can be circumvented by splitting into smaller versions) without mitigating the problem. A good example for functional regulation or monitoring SIFMs is the move of FSB to monitor ETF traded funds. See FSB Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs) (12 April 2011) http://www.financialstabilityboard.org/publications/r_110412b.pdf FSB issued this watch on financial innovation in ETF financial markets and its impact on financial stability; another example for regulating SIFMs is the initiative of NY Fed to reform for tri-party repo systems in the US; also see supra section 2.3 on Systemically Important Financial Markets (SIFMs). 133 See Allegret, Courbis and Dulbecco, Financial liberalization and stability of the financial system in emerging markets: the institutional dimension of financial crises, (2003) Volume 10 No.1 Review of International Political Economy pg.73-92

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has led to the situation of global finance without global regulation. Even though international harmonisation in international financial law has come a long way in banking, securities markets, and taxation, there is always a level of domesticembeddedness for defining financial instrument, financial firm or financial contract. Party autonomy in international contracts is still subject to mandatory rules of a particular jurisdiction. These domestic regulated products are offered world-wide making them transnational. Hence there needs to be the proliferation of meta

norms. However implementation/ supervision of these meta norms will be subject to domestic enforcement forums. The financial crisis of 2007-09 stimulated the political will across countries to embrace more regulatory meta norms.134 The criticism for a global regulator135 is that it may enhance the systemic risk. Different jurisdictions with different regulatory system may enhance healthy regulatory competition, albeit within guidelines of meta norms. This creates islands of regulatory competencies and financial crises will defer in intensity across different jurisdictions. This can reduce systemic impacts to global financial system in a 2008 like crisis. Capital and innovation will flow according to competencies of jurisdiction in legal, regulatory and contractual systems. A top down approach in financial law setting means: soft law or meta norms are set at global levels, while having local regulators to enforce them as hard law. At the same time, self-regulation by means of market based standard setting, by market participants in respective domestic and transnational context, can support the bottom up approach. Maybe regulatory arbitrage could be balanced for a healthy regulatory competitive environment.136

134

See Tietje and Lehmann, The role and prospects of international law in financial regulation and supervision, (2010) 13(3) Journal of International Economic Law 663-682. Also see London G20 summit on global financial regulatory overhaul http://www.g20.org/Documents/g20_communique_020409.pdf 135 Global regulators like Basel Accord and the G-20. The term global regulator envisions a global enforcement agency. 136 See generally C. Goodhart and R. Lastra, Border Problems, (2010) 13(3) Journal of International Economic Law 705-718

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5.5 Concluding remarks Shadow bank regulatory oversight is largely fragmented. Shadow banks briefly came into the spot light during the crisis and slid back into the shadows137. Perhaps this is because shadow banking borders are seamless and they only can be regulatory targets from the perspective of notable market participants, in the context of important global and national financial markets or SIFMs. However for the immediate situation an institution-based approach for strengthening institutions to withstand stress, may be a more pragmatic approach.

137

See Standard & Poor report (n46)

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Concluding Remarks for the Dissertation Shadow banks financial intermediation activity has a trivariate role of risk management, reducing transaction costs and reducing information asymmetry. Constant developments in financial markets and regulatory oversight create homogeneity of financial markets and financial products. However these financial intermediaries break free by creating niches through financial innovation and specialised knowledge. Lord Turner Review recommended reining in their importance by curbing non EVA financial innovation.138 By reducing them from being too important, productive allocation of resources can create financial market stability and allow non EVA activities to die a natural death. It is in market imperfections that financial intermediaries thrive with disproportionate profit margins. Ensuring adequate liquidity levels and healthy competition in financial markets reduces incentives for adverse selection. Transparency in risk profiles and proper pricing of transaction cost reflecting risk-rewards, distort incentives for short-term market players. Increasing underwriting standards and better collateral requirements underlying credit financing can boost confidence in credit markets, consequently credit supply. Global interconnectedness of financial markets suggests there needs to be standardization in regulatory characterisation of transactions which also enhances legal certainty. Finally on the question whether shadow banks require more regulation? The difficulty to answer lies in fact that shadow banks are difficult to define and target for regulatory purposes. Shadow banking participants need to be identified with respect to SIFMs and regulatory targeting should be to curb non EVA activities within such SIFMs. Regulators need to set up intelligent monitoring systems to ensure market development
138

See Lord Turner, The Turner Review: A regulatory response to the global financial crisis (FSA March 2009) section 1.4 where financial innovation should be assessed on the basis of its economic value added (pg. 39)

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and market discipline to ensure stability of SIFMs.139 In future to reduce global systemic risk of financial crisis, a balance between regulatory arbitrage and regulatory competition, can isolate financial risks within jurisdictions/ regions.

139

Resorting to and/ or appropriately revising the remit of Dodd-Frank established Office of Financial Research (OFR) and UKs Financial Conduct Authority (FCA) (n132); also see supra (n131)

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Ap pen dix List of Abb reviatio ns

ABCP ABS AIG BoE CCP CDO CDS CEO CFTC CLO CMO COMI CRA CRD CRT CSE DBD EBDITA EMIR EVA FATCA FDIC FRB FSA FSB FSCS FSMA G20 GAAP GDP GSE HIRE IFRS IRS ISDA LCFI LMA LOLR Asset Backed Commercial Paper Asset Backed Securities American International Group Inc. Bank of England Central Counter Party Collateralized Debt Obligation Credit Default Swaps Chief Executive Officer Commodity Futures Trading Commission Collateralized Loan Obligation Collateralized Mortgage Obligation Centre of Main Interests Credit Rating Agency Capital Requirements Directive Credit Risk Transfer Consolidated Supervised Entities Diversified Broker Dealer Earnings Before Depreciation Interest Tax and Amortization European Market Infrastructure Regulation Economic Value Added Foreign Accounts Tax Compliance Act Federal Deposit Insurance Corporation Federal Reserve Board Financial Services Authority Financial Stability Board Financial Services Compensation Scheme Financial Services and Markets Act Group of Twenty Generally Accepted Accounting Principles Gross Domestic Product Government Sponsored Entities Hire Incentives to Restore Employment Act International Financial Reposting Standards Internal Revenue Service International Swaps and Derivatives Association Large and Complex Financial Institutions Loan Market Association Lender of the Last Resort

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LPFC MBS MiFID MMMF OLA OTC PECO RMBS SAR SEC SIFI SIFM SIV SPV UCTIS UNCITRAL USC V-a-R Limited Purpose Financial Companies Mortgage Backed Securities Market in Financial Instruments Directive Money Market Mutual Funds Orderly Liquidation Authority Over the Counter Post Enforcement Call Options Residential Mortgage Backed Security Special Administration Regime Securities and Exchange Commission Systemically Important Financial Institution Systemically Important Financial Markets Structured Investment Vehicle Special Purpose Vehicle Undertakings for Collective Investment in Transferable Securities United Nations Commission on International Trade Law United States Code Value at Risk

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List of cases
Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty Limited (ACN 113 114 832) (No. 4) [2007] Federal Court of Australia 963 Alitalia Linee Aeree Italiane SpA Connock and Another v Fantozzi [2011] All ER (D) 104 (Jan) (Companies Court, Chancery Division) Re Drax Holdings Ltd [2003] EWHC 2743 (Ch) Re DAP Holding NV [2006] BCC 48 Re Gallery Capital SA and Gallery Media Group Limited [2010] WL 4777509 Ch Div (Norris J) para 22 BNY Corporate Trustee Services Ltd v Eurosail- Uk 2007- 3bl plc and others [2011] EWCA Civ 227 Lehman Brothers Commodity Services Inc v Crdit Agricole Corporate and Investment Bank (formerly Caylon) [2011] EWHC 1390 (Comm) Enterprise v McFadden [2009] EWHC 3222 (TCC) Perpetual Trustee Company Limited v BNY Corporate Trustee Services [2009] EWCA Civ 1160 Indofood International Finance Ltd v JPMorgan Chase Bank N.A. London Branch [2006] EWCA Civ 158 Haugesund Kommune and Narvik Kommune v Depfa ACS Bank [2010] EWCA Civ 579 Raiffeisen Zentralbank Osterreich AG v Five Star Trading LLC [2001] EWCA Civ 68; [2001] 2 WLR 1344 (CA) Kronhofer v Maier [2004] ECR I-6009 Morrison et al. v. National Australia Bank Limited et al. US Supreme Court Case No. 081191 June 24, 2010 North Shore Ventures Limited v Anstead Holdings Inc and others [2010] EWHC 1485 (Ch) Springwell Navigation Corporation v JP Morgan Chase Bank and others ([2010] EWCA Civ 1221

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List of Stat utes

Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 - Sections 165(b) and (j), 171, 619, 621, 1101, 1105 and Title IX. Investment Company Act, 1940 Section 3 (c) 1 and 3(c) 7 Securities Exchange Commission Act, 1934 Section 10(b), 20(a), 144A; Rules 10b-5, 15c3-1, 15c3-3; Regulation T, Regulation D, SHO Regulation, ABS Regulation, as amended. EU Capital Requirements Directive (CRD) 2 and 3, Article 122a of CRD 2 Regulation (EC) No. 593/ 2008 (Rome I) 17 June 2008 Articles 4, 4.2, 12 and 14 Regulation (EC) No. 864/ 2007 (Rome II) 11 July 2007 Article 14 Regulation (EC) No 44/2001 (Brussels I Regulation) 22 December 2000 Article 22(2) FSA BIPRU 9 FSA Conduct of Business Code (COBS) 9 and 2.22 Financial Services and Markets Act 2000 - Section 102 A (3) and 90 A Federal Reserve Act (12 USC) Section 13(3), 23A Banking Affiliates Act of 1982

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Bibliogr ap hy

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