Jonathan Greenacre and Kenneth Tam

Lehman Brothers and HSBC: A Distant Nightmare?

SYDNEY 14 February 2013 - In September 2008 the world watched in disbelief as Lehman Brothers collapsed. Reporters rushed to televise workers emerging from the New York office of Lehman Brothers with their personal belongings.  However, the world’s disbelief turned to panic when it emerged that regulators, particularly those in the US, were largely unable to prevent Lehman Brothers’ failure from severely damaging the world’s financial system. The Federal Reserve chairman Ben Bernanke later told the Financial Crisis Inquiry Commission that it would have been unlawful for the Fed to save the bank. Consequently, and also as stated clearly by Bernanke, developing effective resolution schemes emerged as a key “lesson learnt” from the global financial crisis.

The threat of failure of a systemically important financial institution is still a clear and present danger. As outlined elsewhere on this portal by Justin O’Brien, HSBC has a “Sword of Damocles” hanging over it. After being found responsible for violations of sanctions and the facilitation of money laundering, US regulators entered into a $1.92 billion deferred prosecution with the bank. Furthermore, the Department of Justice forced HSBC to impose an external monitor for the duration of the five-year period in which the deal is operational. Crucially, if it emerges that HSBC fails to comply with the deferred prosecution agreement the bank’s licence may be revoked, which, given the institution’s systemic importance, like Lehman Brothers, could impact the stability of the global financial system. 

Or will it? Answering this question involves determining whether the global community has learnt the lesson of Lehman Brothers and developed effective cross-border resolution schemes. Regulators in some major jurisdictions have certainly tried. On 10^th December 2012, the Federal Deposit Insurance Corporation (FDIC) and the Bank of England released a joint paper outlining their plans on how to resolve systemically important financial institutions operating in the United Kingdom and United States (US-UK plan).  On 15^th January 2012, the EU President Barroso said it was an ‘utmost political priority’ to have a proposal for the Single Resolution Mechanism (SRM) which would be the European bank resolution scheme as part of a European Banking Union.

The technical details of these plans still need to be determined, particularly in Europe.  However, as explored by this piece, and as will be developed by future pieces to be placed on this portal, the plans provide some guidance on how well equipped we are to deal with the fall out from the failure of an institution like HSBC.  This piece provides an overview of the ideas manifested in the two plans.

The Two Bank Resolution Schemes

US-UK plan

The US-UK plan is clearly justified by the need for clear regulatory policies to be followed in the event of a collapse of a systemically important institution like Lehman Brothers. It seeks to limit risk taking by placing risk of failure on shareholders and creditors, rather than taxpayers. The plan also aims to minimise the impact on the financial system by maintaining the continuity of critical services and keeping ‘sound subsidiaries’ open.

A central pillar of the US-UK plan is a top-down ‘single point of entry approach’ whereby the home authority alone takes charge of the parent company. A coordinated strategy would purportedly help the US and UK to avoid working at cross purposes or developing and acting upon conflicting plans. Having one authority in charge is designed to increase predictability, and reduce the conflict where authorities have to act according to their own different national regulations.

Mechanisms of the US-UK plan involves restructuring methods such as closing some parts of the bank, converting unsecured debt into equity, and replacing responsible senior management. Ultimately these tools are designed to ensure that in the event of bank collapse shareholders would lose all value and the claims of unsecured creditors would be written down to reflect any losses that shareholders did not cover.

Trust is a key issue for the UK-US Plan. Are regulators in one country really likely to sit on their hands while regulators in the bank’s host jurisdiction implement the resolution scheme? Paul Tucker, the Bank of England deputy governor, asserted that if an American systemically important financial institution failed, UK authorities would trust US authorities and not intervene themselves. Interestingly, Martin Gruenberg, chairperson of the FDIC, did not reciprocate and make a similar assurance. A variety of other issues are also important. For example, subordinated debt would become unattractive under the measures above, which could raise the cost of debt. Furthermore, regulatory arbitrage may occur if other countries adopt a different approach that banks think is preferable to that offered by the US and UK.

EU Scheme

On 12 December 2012 agreement was reached over the first pillar of an European Banking Union: Single Supervisory Mechanism (SSM).  The focus is now on bank resolution. According to a roadmap that was released by the European Commission, the first step is to implement the Recovery and Resolution Directive (RRD).  The RRD is supposed to be finalised by June 2013, with implementation ‘a matter of priority’. The RRD sets common national standards, and ensures that national authorities are equipped with harmonised tools to resolve and recover banks.  These include early interventions, bail in and other restructuring mechanisms.

For countries participating in the European Banking Union, the next step is the creation of a Single Resolution Mechanism (SRM).  The SRM means that there is the one  European Resolution Authority, which will ensure that there is a coordinated approach to resolution, avoiding the problem of national authorities failing to cooperate.  However, as outlined by another piece on this portal written by Dr Grünewald, negotiations for a SRM are likely to be protracted and the details of any potential arrangements are uncertain. The European Commission’s ‘blueprint for a deep and genuine economic and monetary union’, contained principles that the SRM should follow, for instance shareholders and creditors would be the first in line to bear the costs of resolution.

Funding is a major issue for the potential SRM. It has been suggested that the scheme would be financed through a European Resolution Fund, which would be raised through ex ante risk-based levies on banks. The scheme should be fiscally neutral over the medium term and any public assistance is supposed to be recouped through ex post levies on the financial industry. Doubts were raised in a report which was released by the UK House of Lords on 12 December 2012 as to whether a resolution fund financed by bank levies alone will be too small to be effective.

As Dr Grünewald argues, even if industry provides ex-ante collected funds, losses exceeding this amount will almost certainly need to be covered by putting taxpayer money at risk. Will European taxpayers agree to this arrangement?  As with many issues relating to the European Union, Germany’s voters will be key.  The German Chancellor Angela Merkel has already emphasised that any resolution fund must not be at the cost of taxpayers and she may not change her mind before German elections which are set for September 2013.

The Threat Remains

Ultimately, it is too early to judge the direction taken by the US-UK and European plans. They certainly demonstrate the kind of thinking required to deal with a Lehman Brothers-type collapse, and to minimise any potential failures from the collapse of a systemically important financial institution such as HSBC. As with many complex arenas of financial regulation, it is unclear how effective these measures will be until they are used.  Until then, the failure of systemically important financial institutions remains a clear and present danger.