LEXIS-NEXIS® Congressional Universe-Document
LEXIS-NEXIS® Congressional
Copyright 1999
Federal News Service, Inc.
Federal News Service
MARCH 25, 1999, THURSDAY
SECTION: IN THE NEWS
LENGTH: 3139 words
HEADLINE: PREPARED STATEMENT OF
DOUGLAS H. JONES
SENIOR DEPUTY GENERAL COUNSEL
FEDERAL DEPOSIT INSURANCE CORPORATION
BEFORE THE
SENATE BANKING, HOUSING AND URBAN AFFAIRS COMMITTEE
SUBJECT -
BANKRUPTCY REFORM LEGISLATION
BODY:
Chairman Gramm, Ranking Member Sarbanes, and members of the Committee, the
Federal Deposit Insurance Corporation appreciates the opportunity to present
its views on certain banking related matters that may be considered as part of
comprehensive
bankruptcy reform. My remarks will focus largely on Title X of last year's conference report for
the
Bankruptcy Reform Act of 1998 (Title X) which is identical to H.R. 833 introduced by
Representative Gekas. S. 625, legislation recently introduced by Senator
Grassley currently does not include critical aspects of Title X and we would
urge that S. 625 incorporate all of the provisions in Title X for the reasons I
will cover in my testimony. I will also briefly touch on revisions to the Truth
in Lending Act that were found in last year's conference report
on
bankruptcy reform.
Title X adopts proposals of the President's Working Group on Financial Markets.
Similar legislation, H.R. 1161, the Financial Contract Netting Improvement Act,
has recently been introduced by Banking Committee Chairman Leach, Ranking
Member LaFalce, and Financial Institutions Subcommittee Chairwoman Roukema. The
FDIC participated on the Working Group and assisted in drafting the group's
proposals. We strongly support language such as that contained in Title X of
last year's
bankruptcy reform conference report and H.R. 1161.
Title X will result in more consistent and predictable rules to govern events
when one party to a financial derivative contract becomes insolvent. Enactment
of the legislation will clarify the rights of the parties to a derivative
contract and the treatment of those contracts if a party becomes insolvent. As
a result, market participants will have a better understanding of their fights
and will be able to more accurately assess and manage the risks arising from
derivative contracts. The legislation will also clarify the FDIC's right, as
the receiver for failed banks and thrifts, to transfer qualified financial
contracts (QFCs). In addition, the legislation will enhance the ability of the
FDIC to transfer QFCs from the failed bank or thrift to new solvent parties,
thereby reducing disruption of contracts and the markets.
The Role of Derivatives and Cross-Netting
I would like to provide some background on the role that financial derivatives
play in our financial markets and economy. Banks and corporations use
derivative contracts to shape earnings, market, liquidity and credit risk
profiles. Some banks use these contracts strictly as end-users to manage their
internal risk profiles, while other dealer banks are net providers of these
contracts. Dealer banks provide these contracts both to end-user banks and to
end-user corporate clients and, thus, are important links in the chain of
providing financial intermediation services. In addition, these banks match
end-users with offsetting risk profiles. They also enter into contracts with
end-users that shift these risks directly to them. Dealer banks have a broader
array of markets to distribute these exposures and greater technical expertise
to effectively manage these risks on a global basis than do most end-users.
The benefits of derivative contracts to the world economy include less
concentrated
risk in end-user banks and end-user corporations. By entering into these
contracts, the end-user is afforded the opportunity to secure more stable
earnings, for example, when interest rates change dramatically. Derivative
contracts allow end-users to concentrate expertise in the core business lines
that are most familiar to them with only a small diversion of resources to
understand and manage the risks of the contracts.
One of the key elements in reducing risk to the capital markets is the
availability of close-out netting for certain types of financial contracts in
the event of the insolvency of one party. Since adoption of the
Bankruptcy Code in 1978 and amendments to the Federal Deposit Insurance Act (FDI Act) in
1989, federal law has been amended several times to provide greater certainty
to participants in our capital markets if one party becomes insolvent.
Netting may be defined as taking what I owe you and what you owe me on several
contracts and subtracting or
"netting" those two figures to arrive at a single amount for payment by one of us.
Netting can be a valuable credit risk management tool in all multiple
transaction relationships by reducing the credit and liquidity exposures to
counterparty insolvency. It does this by eliminating large funds transfers for
each transaction in favor of a smaller net payment.
The series of"netting" amendments to the
Bankruptcy Code and the FDI Act over the past two decades were designed to further the
policy goal of minimizing the systemic risks potentially arising from certain
interrelated financial activities and markets. Systemic risk has been defined
as the risk that a disruption -- at a firm, in a market segment, to a
settlement system,
etc. -- can cause widespread difficulties at other firms, in other market
segments or in the financial system as a whole. Netting helps reduce this risk
by reducing the number and size of payments necessary to complete transactions.
As a result, it allows greater liquidity in the system by reducing the amounts
necessary for each party to settle its transactions. If participants in certain
financial activities are unable to enforce their rights to terminate financial
contracts with an insolvent entity in a timely manner, and to offset or net
payment and other transfer obligations and entitlements arising under such
contracts, the resulting uncertainty and potential lack of liquidity could
increase the risk of an inter-market disruption.
Statutory Background
The FDI Act, the Federal Deposit Insurance Corporation Improvement Act
(FDICIA), the
Bankruptcy Code, and the Securities Investor
Protection Act of 1970 are the principal statutes that determine what happens
to derivative and related financial contracts when one party becomes insolvent.
These laws vary significantly in how they define applicable contracts and the
rights and obligations of counterparties. Perhaps most important is the
ambiguity and uncertainty created by possible overlap and inconsistencies
between the statutory schemes. One of the primary goals of the Working Group
has been to enhance predictability for market participants by harmonizing the
definitions and substantive provisions of these statutes.The
Bankruptcy Code governs insolvency proceedings for most corporations, while the
Securities Investor Protection Act of 1970 governs insolvency proceedings
involving stockbrokers who are members of the Securities Investor Protection
Corporation. Insolvencies of insured depository institutions are not governed
by the
Bankruptcy Code, but by the bank receivership provisions of the FDI Act and the National
Bank Act. FDICIA also
includes provisions that govern the treatment of netting contracts between
financial institutions.
In these statutes, Congress has taken steps to enhance the availability of
netting for derivatives and to minimize the risk of a system-wide disruption in
our financial markets. For example, both the
Bankruptcy Code and the FDI Act contain provisions that protect the rights of financial
participants to terminate certain types of financial contracts following the
bankruptcy or insolvency of a counterparty to such contracts or agreements. Furthermore,
other provisions prevent transfers made under such circumstances from being
avoided as preferences or fraudulent conveyances (except when made with actual
intent to defraud).
Protections also are afforded under U.S. law to ensure that the netting, set
off and collateral foreclosure provisions of such transactions and master
agreements for such transactions are enforceable. Finally, FDICIA protects the
enforceability of close-out netting provisions in
"netting contracts"
between
"financial institutions." FDICIA states that the goal of enforcing netting arrangements is to reduce
systemic risk within the banking system and financial markets.The FDI Act
confirms the availability of close-out netting when an insured bank or thrift
fails. It does so by allowing counterparties to specifically defined contracts,
called
"qualified financial contracts" or QFCs, to terminate their contracts, net their exposures and recoup positive
claims against the failed bank or thrift from any security provided before the
failure. QFCs are defined as consisting primarily of financial derivatives and
similar instruments and are further defined by reference to statutory
definitions for five types of contracts: securities contracts, commodity
contracts, forward contracts, repurchase agreements, and swap agreements.
Upon appointment of the FDIC as receiver for an insured depository institution,
QFC counterparties receive certain benefits and
rights which are not available to parties to other types of contracts. First,
any repudiation or transfer of the QFC by the receiver must occur by 12:00 noon
local time on the business day following the appointment of the receiver.
Second, if the receiver does not provide notice of the repudiation or transfer
of the QFC by close of business (New York time) on the business day following
appointment of the receiver, the QFC counterparty can exercise contractual
rights to terminate the QFC and offset or net out any termination values,
payment amounts, or other transfer obligations under the agreement which arise
upon appointment of a conservator or receiver. Third, the receiver or
conservator cannot avoid any transfer of money or other property made in
connection with the QFC, unless the recipient had actual intent to hinder,
delay or defraud the institution, the creditors of the institution or any
receiver or
conservator of the institution. Fourth, if the receiver is to transfer any QFCs
to a third party, the receiver must transfer all QFCs with the same
counterparty(including its affiliates) to a single depository institution.
Finally, if the receiver repudiates a QFC, the counterparty may recover damages
incurred up to the date of the repudiation (rather than to the date of
appointment of the receiver as with most other agreements under the FDI Act),
and the recoverable damages may include reasonable costs of cover or other
reasonable measures of damages used in the industry. When enacted in 1991,
Sections 402 through 404 of FDICIA provided a significant expansion in the
statutory protection afforded to contractual netting. Unlike the FDI Act
provisions, these protections are not limited to QFCs. FDICIA confirms the
enforceability of the netting of payment obligations among
"financial institutions" under a
"netting contract." Some have
argued that the FDICIA netting provisions permit closeout netting of such
contracts irrespective of the FDIC's rights as receiver under the FDI Act. The
FDIC believes that FDICIA and the FDI Act must be interpreted in harmony to
permit the FDIC to enforce agreements under section 1821 (e)(12) unless the
agreements are QFCs under section 1821 (e)(8).
Both the FDI Act and the
Bankruptcy Code grant those who have entered into financial derivative contracts with
parties that subsequently become insolvent greater rights than these statutes
grant those who enter into most contracts. In the case of a derivative
contract, a market participant has greater rights to terminate the contract and
to net, dollar for dollar, its obligations to the insolvent against the
insolvent's debts to the counterparty. The statutes are, of course, much more
intricate than this brief description.While these laws provide significant
assurances that the risk reduction
benefits of close-out netting are available under U.S. law, the provisions of
Title X are an important step toward harmonizing these statutory provisions
which were enacted over more than a decade. In addition, Title X permits our
statutes to remain abreast of innovations that have occurred in our financial
markets since 1989. As a result, enactment of Title X is a crucial step to
maintaining the U.S. as the leader in financial innovation and risk management.
Provisions of Title X
Title X addresses several significant issues for bank receiverships, while
providing additional clarification and consistency that reduces systemic risk
in all insolvencies. Title X includes three principal elements.
First, the legislation strengthens the statutory protections for netting of
financial market contracts. It revises and clarifies the definitions of the
types of contracts that benefit from
netting in line with market innovations and practice. This provides additional
certainty to market participants and improves their ability to accurately
assess and manage risks. The legislation also clarifies that, under the FDI Act
and the
Bankruptcy Code, cross-product netting can be achieved through the use of a master
netting contract. As a result, the legislation would expand the availability of
the riskreduction benefits of close-out netting to agreements encompassing a
number of financialmarket contracts and, thereby, further reduce the potential
settlement risks to market participants.
Second, the proposed legislation makes the treatment of financial market
contracts more consistent under the FDI Act and the
Bankruptcy Code. Improved consistency between the insolvency regimes applicable to banks
and non-banks has been one of the primary goals of the Working Group. There is
little justification for treating identical financial market contracts
differently dependent solely upon whether the counterparty is
an insured depository institution subject to the FDI Act or an entity subject
to the
Bankruptcy Code. The importance of consistent insolvency treatment to risk management in
the financial markets strongly recommends enactment of this legislation.
The legislation also provides certain additional substantive and technical
amendments that clarify certain provisions and improve the consistency in the
treatment of these financial market contracts between applicable laws. For
example, the legislation would apply the same rules to uninsured national banks
and Federal branches and agencies that apply to insured institutions in order
to limit inconsistencies. These changes will go far to providing a clear
playing field for market participants.
Third, the legislation clarifies the rights of the FDIC as receiver for a
failed bank or thrift. An important component of reducing systemic risk to the
financial system is the orderly resolution of insolvencies involving
counterparties to such
contracts. The FDIAct allows the FDIC, when serving as receiver for an
insolvent insured depository institution, the opportunity to review the status
of certain contracts to determine whether to terminate or transfer the
contracts to new counterparties. These provisions provide the receiver with
flexibility in determining the most appropriate resolution for the failed
institution and facilitate the reduction of systemic risk by permitting the
transfer, rather than termination, of such contracts. These provisions also are
important to permit the FDIC to fulfill its statutory mission to preserve
confidence in our banking system by protecting insured depositors and promptly
resolving insured banks and thrifts that fall.
To ensure an orderly resolution of such insolvencies, the proposed legislation
clarifies that under the FDI Act, a conservator or receiver of a depository
institution has one business day to transfer qualified financial contracts to
another financial institution. This clarification will help ensure that the
resolution of a
failed depository institution can be accomplished at the lowest possible cost
to the deposit insurance funds administered by the FDIC, while preserving for
market participants the ability to promptly net out their contracts with failed
depository institutions.
We believe the legislative proposal will reduce systemic risk in our financial
markets, while balancing the public interest in effective and orderly
resolution of failed insured banks and thrifts. Clarification of these
provisions also is important for the continuation of financial market
innovations and for continued stability and growth of our financial system.
This legislation will play an important role in allowing the United States to
maintain its world leadership in providing a legal structure that
facilitatesprudent oversight and risk management while protecting the markets
from systemic risks potentially created by insolvencies of market participants
by ensuring the availability of
termination and close-out netting.
Truth in Lending Act (TILA) Amendments
Sections 112, 114, and 1128 of the Conference Report attempt to be to reduce
the potential for
bankruptcy by enhancing disclosures to consumers of open-end credit that is secured by a
dwelling. Under section 112, the Federal Reserve is required to conduct a study
to determine if consumers receive adequate information concerning the tax
deductibility of interest paid on such mortgages, particularly with reference
to mortgages where the amount of credit is greater than the value of the
dwelling put up as security. Section 114 would amend the TILA to require new
disclosures under any credit or charge card account under an open-end consumer
credit plan where minimum monthly or periodic payment is required, in addition
to those disclosures currently required by section 127 of the TILA.
Section 114 also
requires the Federal Reserve to conduct a study to
"determine whether consumers have adequate information about borrowing
activities which may result in financial problems." If the Federal Reserve determines that additional disclosures to consumers
regarding minimum payment features are warranted, it shall promulgate
appropriate regulations. Section 1128 of the bill would amend section 127 of
the TILA to provide that a creditor of an open-end account may not terminate
thataccount prior to the date of expiration solely because the borrower hasn't
incurred any finance charges on the account. In other words, a credit card
lender may not terminate someone's account just because the accountholder has
kept the account current and not allowed any interest charges to accumulate.
Conclusion
In closing, let me reiterate the FDIC's support for all the provisions of Title
X. We urge the
Committee to include the provisions of Title X of last year's conference report
on
bankruptcy reform left out of Title IX of S. 625. Passage of the improvements to the netting of
financial contracts will benefit the market, market participants and the
creditors of failed banks and thrifts. It will fix a problem before it arises.
Mr. Chairman, I would be happy to answer any questions you may have at this
time.
END
LOAD-DATE: March 26, 1999