Risk Protection Measures for the Bank - Essay Example

Risk protection measures for bank “A” In assessing the risks in a derivative transaction, the most important factor to be considered is the risk of default, which occurs when one party fails to keep to its obligations to make payments, since it is unable to do so. (FN1). In the case of bank A, the failure by bank B to make its designated payments by the due dates could create potential risks, especially when a notice for payment within three days also fails to achieve the desired results. This situation may be categorized as the credit risk of default, therefore Bank A can take certain pre-emptive measures to mitigate such risks. Bank A may have the option to propose an early termination date in order to avoid further losses (FN3). However the contract between the two banks should make provision for such losses and one of the best options open to Bank A is to enter into an ISDA Agreement. An ISDA Agreement allows a bank to operate in financial markets while conforming to strict regulations. The EU Directive 2001/24/EC dated 4 April 2001 has laid out specific guidelines on the winding up of credit institutions and will apply to both bank A and Bank A who are in Europe. (a)Applying Article 10 of the Directive, all activities of winding up will be carried out in the home state of Bank B (b) Article 23 allows for set off provisions for Bank A (a) Article 25 specifically clarifies that netting agreements will be solely governed by the nature of the agreement that exists between the two parties – Bank A and B. Therefore, Bank A can cope with the risks by introducing appropriate clauses into the Schedule to the ISDA agreement. If Bank A has any intimation of the potential winding up of Bank B and then enters into any financial arrangements with them, recoveries will be limited, despite any risks. However, if at the time of entering the agreement, Bank A is not aware of any winding up, then financial obligations due to it from Bank B may be secured through the means outlined below. Definition of Directive: Derivatives are financial instruments that are used for financial speculation and their fluctuating value is caused by volatility in the financial markets1. Counterparties enter into derivatives for purposes of hedging and arbitrage to be derived in financial transactions through the management of asset liabilities2. First Point: Enter an ISDA Agreement and use Credit Support Deed: Contractual provisions under ISDA Agreements include a Master Agreement which is standard all contracting organizations and an attached Schedule may be tailored according to the requirements of the two parties. Therefore, Bank A can tailor the Schedule by including a clause that will also regulate oral trading arrangements of the two parties. When a contractual arrangement is first negotiated by Bank A, it can make use of the ISDA Credit Support Annex or the Credit Support Deed, requiring Bank B to provide collateral against anticipated losses that may occur. The Credit Support Annex may be appended to the master ISDA Agreement but will not create a security interest over the collateral. A separate Credit Support Deed means that Bank A acquires the charge over the collateral assets supplied by Bank B. Therefore Bank A can make good any losses it incurs, provided details of such charge is delivered to the Registrar within 31 days in order to become legally enforceable under section 395 of the Companies Act of 1985. If there is a default in dues by Bank B, the value of the collateral will be surrendered to Bank A, reducing risk. Second Point: Set off to avoid “cherry picking”: The provisions of the EC regulation include prior intimation to all creditors (which includes Bank A)about the winding up procedures of Bank B. Under Article 23 of the Regulation, Bank A will be permitted to square off the debts owed to bank B against those owed to itself in multiple trading transactions, through the process of netting. Every individual derivative transaction may have different dates of payment, etc however by combining some of those payments into one, (for example, those that use a particular currency), close out netting can combine all dues to determine net value, will enable such common debts to be paid on a combined basis rather than being paid individually3 This netting option must be specified in the contract to offset “cherry picking” by liquidations when the winding up procedure is initiated. Third Point: Jurisdiction to be included in contract: Conflict of laws will occur between the home state of Bank A which is England versus the home state of bank B. Although they are both in Europe and subject to the Directive, nevertheless the winding up proceedings occur in accordance with the laws of the home country of Bank B, which may operate according to a different set of laws on insolvency and winding up. Therefore, Bank A must specify in the initial contract that for resolution of conflicts on the agreement, UK jurisdiction will prevail so that UK law can be applied, especially since the branch office of bank B is also in England. Point Four: Benefit of amendments to English law on winding up: If the agreements is set within the jurisdiction of English law, then the set off procedures will be governed by Section r.4.90 of the Insolvency Rules of 1986, which will be applicable in the winding up of a Company. The set off procedure to determine a net balance must be inclusive in the contract and cannot be modified by the parties.4 Resolution of the debt will generally work in favor of the creditor in the English Courts – in this instance Bank A5. Through recent amendments which have been brought to the Insolvency Rules in the case of winding up of a Company, the Court will also take into account the amounts that are due at a later date. Section r.4.86 enables valuation by the courts while rr.4.91-4.93 allow the facility of discounting debts in spite of unpredictable aspects such as exchange rates or interest payments. This will aid in recoveries for bank A. Point Five: Inclusion of automatic termination Clause: An automatic termination clause can be included in the agreement when notice of winding up proceedings is intimated, so that Bank A can opt out of the agreement early and will be protected from continuing to trade with a Company that has already entered the insolvency stage. Since the EU Directive ensures that Bank A as a creditor will be informed when such proceedings are initiated, therefore the execution of the termination clause can be made contingent upon such notice. Point Six: Inclusion of an Event of default Provision: Additionally Bank A may also protect itself through the incorporation of an Event of default provision through the facility of additional termination events on credit dues. Therefore, if there is default by bank B for any reason and dues are not paid within a specified period, subject to a grace period as may be agreed to between the parties, Bank A will by default opt out of the contract. This provides an important avenue of relief to bank A to escape from liability in the event of Bank B’s winding up. In conclusion, all the measures above, included into the initial contract, could protect Bank A from risk. Adherence to the UK Companies Act of 1985 must be ensured since the revised amendments also make provision for payment of dues that may be owed in the future, through necessary procedures for calculation and discounting of amounts that are likely to be owed. Moreover, Bank B cannot contract out of Section 302 of Companies Act of 1948 because it will be contrary to public policy.5 As a result, Bank A will be able to recover most of what is due to it from bank B and will minimize the extent of its losses. Bank B in Ruritania Definition of Directive: Derivatives are financial instruments that are used for financial speculation and their fluctuating value is caused by volatility in the financial markets1. Counterparties enter into derivatives for purposes of hedging and arbitrage to be derived in financial transactions through the management of asset liabilities2. Provisions applicable to agreements between bank A and B: If Bank B is in Ruritania which is not within the European Union, then the provisions of the EC Directive cannot be enforced against Bank B, hence the provisions of Articles 10, 23 and 25 will not apply. Bank A can enter into an ISDA Agreement with Bank B and can modify its schedule to include contractual provisions tailored to the needs of both parties. It can also execute a separate Credit Support Annexture, requiring collateral. However, the provision to apply set-offs (Article 23) or to be mandatorily informed of winding down provisions (per Article 10) may not necessarily apply. Secondly, in reference to netting provisions, it will not be the agreement between Bank A and Bank B that will be determine execution of payment of debts, etc. For example, assuming Ruritania is in the United States, it will be the FDIC (Federal deposit Insurance Corporation) that will have the legal authority to close banks and will regulate repayment of debts, therefore the degree of control Bank A will have over the risk factor will be reduced. The essential point at issue is that agreements entered into under different forms such as for example International foreign Exchange Master Agreements, will mean that Bank A will have less control over the risk factor, because the application of netting, offset and set off is not applied uniformely in every case by the regulating authorities. Another factor that must be considered is that creditors of an institution that is winding up have different status – for example debts of secured creditors will be paid before the debts of unsecured creditors and it is generally difficult to completely avoid “cherry picking” by liquidators in such cases. Since the provision of set off in Article 23 cannot be applied in this case, Bank A does not have any guarantees that a net balance can be derived. Possibly, a liquidator may proceed against Bank A for debts owed to Bank B, inspite of other dues from bank B which may rank lower on the scale of repayment to Bank A.. However Bank A can protect itself by choosing to enter into an ISDA Agreement and using the facility of collateral assets applied by bank B towards potential losses by making use of the Credit Support deed. It can also specify the jurisdiction of English courts, so that the provisions of the Companies Act and the Insolvency rules can be applied as far as possible. Bibliography British Eagle International Airlines Ltd v Compagnie Nationale Air France (1975) (HL) 1 WLR 758 Edwards, Steven, 2002. Legal principles of derivatives Journal of Business Law, January pp1-32 Hudson, 1998. The Law on Financial derivatives pp 9-13 McKnight, Andrew, 1999 A review of developments in English law during 2005: part 2 Journal of International banking Law and regulation 2006, 21(4) pp 176-197 Stein v. Blake [1996] 1 A.C. 243, per Lord Hoffman Read More