Earlier this month, Stephen Lubben at Dealbook posted an interesting piece querying whether there may be hidden costs associated with giving banks huge breaks in their capitalization requirements under Basel III for close-out netting, the clause in the ISDA master agreement that provides that under a long list of specified conditions such as bankruptcy, reorganization, nationalization and so on, one of the parties to a swap transaction can demand that the two sides close out all their obligations and net them all out. As I explain in detail in my book, Collateral Knowledge, the reason the parties want to do this is that under modern bankruptcy law, even if Bank A cannot pay Bank B because it is bankrupt, Bank B is still obligated to pay Bank A. If the two sides have netted out their obligations though, the amount Bank B owes Bank A in this situation will be much less–it’s obligation minus whatever Bank A owed it but couldn’t pay.
One chapter of my book is devoted to the events surrounding the passing of a Netting Law in Japan that would guarantee that netting was enforceable. At the time, ISDA, the International Swaps and Derivatives Association, was busy pushing such laws through in every major jurisdiction in which derivatives trading occurred. And as Lubben says, everyone in the industry asserts that netting is a universal good. In fact, in the entire period of my research I never heard a single person–not a regulator, not a market participant, not even an academic specializing in derivatives–suggest that there were any possible costs associated with netting. But as my research progressed I became increasingly curious about some of the possible costs. Indeed, ISDA’s furious drive to get netting laws passed all around the world suggested to me that someone at ISDA had to believe that there were at least some judges out there who, faced with a case about the enforceability of close-out netting agreements, might see enough costs there to decide to hold the agreements unenforceable. And yet when I queried people about these issues–even people without a direct pecuniary stake in the matter such as academics and bureaucrats–the question was just dismissed again and again as completely out of left field.
Lubben focuses on one possible problem with close-out netting, the fact that the parties can invoke the clause under the contract for a laundry list of reasons, not simply for actual bankruptcy. His concern is that “letting everyone rush to the exits in time of financial crisis” increases systemic risk. I am not sure if this is as big of a problem in practice as it appears to be on paper. My research documents numerous occasions in which parties could have invoked the terms of the netting clause but chose not to do so for a variety of interesting and complicated reasons relating to their calculation of what was in their long term best interest. One of the things I try to do in the book is to show how distant law in the document may be from law in practice in the financial markets and this is an example.
However I have another kind of concern about netting agreements. What I think Lubben is really getting at in his comment is that they run an end game around national bankruptcy laws. This means not only that the parties get to liquidate their agreements for reasons that would not be valid under the bankruptcy law but also that in cases of real bankruptcy or reorganization the parties get out of the rules governing who gets paid first. Under the bankruptcy laws of every country I know, swap counter parties would be close to the end of the line of creditors to be paid in bankruptcy. In other words citizens, through their legislatures, have decided that when there is not enough money left in a bank to pay everyone, others–secured creditors, employees, and so on–should be paid first. Moreover if you compare the class of creditors who would be paid first with the average class of swap counter parties you will find that the former are more local–employees, landlords, tax authorities–while the latter are far more likely to be offshore. But yet netting says forget all that, swap counter parties’ claims come first, before we even get to the bankruptcy priority list. No wonder ISDA members were worried some judges might not see things their way.
And yet in Japan where I did my research there was absolutely no public debate about the netting law. No NGO took up the issue; no bankruptcy law professors raised any concerns; the opposition did not even raise any questions about it. Perhaps it is not too late, in the context of Basel III, to simply begin to ask whether the benefits to market stability entailed in netting really do outweigh the very serious social costs. That would require at least beginning to recognize what those costs are however.