GLOBAL PERSPECTIVES OF REGULATORY REFORM FOR

SHADOW BANKING:

IMPACT ON THEIR BUSINESS MODELS

Samuel George

This essay was originally submitted for the degree of Master of

Laws of Brunel University, London. Further modifications have

been made to the original version.

Originally submitted in September, 2011

Contact: casammy@gmail.com Mob:+447448796280

i

INDEX

Abstract ii

Acknowledgement iii

Introduction 1-2

Framework of Regulatory Objectives 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 Gatekeeper‟s 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 26-41

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

ii

3.3.2 Secondary market participants – like Hedge funds & Private Equity……38

3.3.3 Corporate governance rules………………………………………………39

3.4 Concluding remarks………………………………………………………...40

Motivations for Shadow Banking Financing Structures 42-53

4.1 Bankruptcy remoteness & insolvency remoteness in financing

structures………………………………………………………………………42

4.2 Cross border tax structuring……………………………………………….47

4.3 Applicable law or Governing law…………………………………………48

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 60-61

Appendix – List of Abbreviations 62-63

List of Cases and Statutes 64-66

Bibliography 66-71

iii

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 Systemically Important Financial Markets (SIFMs),

based on “functional regulation” may be better regulatory targets than Systematically

Important Financial Institutions (SIFIs), or “institution-based regulation”.

iv

Acknowledgements

I am really grateful and appreciative of this opportunity to undergo the Master‟s 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.

v

P a g e | 1

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-depository-

banks 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-to-

fail”. 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

P a g e | 2

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: institution-

based, 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 Principles

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 à 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 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.

P a g e | 4

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 See F. Allen, A.M Santomero (n1) 4 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 330–356; 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.

P a g e | 5

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://econ-

www.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

P a g e | 6

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 cross-

border 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 BoE‟s 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. 19See 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 re-

securitised 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 See supra Morgan Ricks (n19) pg.109-114 and 122-136 21 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.25

An 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 originator‟s 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 originator‟s 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.

P a g e | 11

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

bank‟s 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.27

In 2004 SEC had changed its net capital rules, to allow net capital to be

computed at CSE Holding Company level (Holding Companies of regulated broker-

dealers) 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

Commission‟s (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

P a g e | 12

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.30

A 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 O‟Dea, „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 )

P a g e | 13

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 other‟s

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 banking‟s 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.

P a g e | 14

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 Gatekeeper’s 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. 35Item 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.

P a g e | 15

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 Citigroup‟s 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.

P a g e | 16

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-morgan-

pricewaterhousecoopers-clent-assets.

P a g e | 17

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 regulator‟s 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 re-

characterize 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.

P a g e | 18

sustainability of financial system; and proof against regulatory arbitrage. The cost-

benefit 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 firm‟s structure and activity. Over the last few decades,

there has been a shift in banking business model, from portfolio lending to originate-to-

distribute 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 firm‟s 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 José 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

P a g e | 20

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, private-

equity 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

P a g e | 21

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 (non-

financial) 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.

P a g e | 22

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) “Too-

big-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. 227-

235.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 Board‟s 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.

P a g e | 23

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 See Pozsar, Adrian, Ashcraft and Boesky (n17) pg.26-42 54 See infra chapter 5 (n132) on FSB‟s market watch on ETF stability risk issues and regulatory framework for better

collateral.

P a g e | 24

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 re-

hypothecated 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 borrower’s 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, mortgage-

backed 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. Krieger‟s 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

P a g e | 27

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 bank‟s

Tier1 capital. Dodd-Frank Act still purports to preserve a banking entity‟s 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 bank‟s 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 Rule‟s 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.

P a g e | 29

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 payer68

. 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 pre-

determined 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

P a g e | 31

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 co-

operation. 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 client‟s 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 debtor‟s 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

P a g e | 32

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

P a g e | 33

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.77

These 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 “re-

securitisations”; 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. 79See 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 SEC‟s 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 non-

financial (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) 81See 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-launch-

reignites-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

P a g e | 36

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 pre-

defined 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

P a g e | 37

significantly, whereas American firms sold substantially default protection against

Greece‟s 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 issuer‟s outstanding capital. An additional precautionary circuit-

breaker 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 376-

425. Also see Annette L. Nazareth ,„The SEC‟s 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-rule-

implications-and-ambiguities/. For penalties in market manipulation relevant legal provisions are given in EU

Market Abuse Directive, 2003 and SEC‟s Sec 10 (b) and 20 (a) read along with SEC rule 10b-5.

P a g e | 38

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 “skin-

in-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)

P a g e | 39

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 firm‟s 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 Walker‟s

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-b418-

00144feabdc0.html#axzz1XDYAHkFw. 92 See Burdett and Dockrell, „AIFMD Directive: Competing directives‟, (2010) Volume 29 Issue 8 International

Financial Law Review 39

P a g e | 40

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. Repo‟s 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 Enron‟s market purchases of its stock and

commercial papers prior to bankruptcy filings, were not protected from this safe

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 originator‟s 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

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 Court‟s ruling

in the case of Heart of La Défense SAS and Sàrl 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 Héricotte, „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.105

The 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, pre-

occurrence 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 Crédit 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

It‟s 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-of-

interest regimes in securitisation deals, following the SEC v Goldman debacle.

122 See Andrew F. Tuch (n35). Also see supra (n88) on liabilities under securities law 123 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-pricing”125

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 See supra Sandra C. Kriegar‟s speech (n 59). 126 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.

P a g e | 57

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 à 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

P a g e | 58

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 “domestic-

embeddedness” 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 regulator”135

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)

P a g e | 61

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 UK’s Financial Conduct Authority (FCA) (n132); also see supra (n131)

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Appendix – List of Abbreviations

ABCP Asset Backed Commercial Paper

ABS Asset Backed Securities

AIG American International Group Inc.

BoE Bank of England

CCP Central Counter Party

CDO Collateralized Debt Obligation

CDS Credit Default Swaps

CEO Chief Executive Officer

CFTC Commodity Futures Trading Commission

CLO Collateralized Loan Obligation

CMO Collateralized Mortgage Obligation

COMI Centre of Main Interests

CRA Credit Rating Agency

CRD Capital Requirements Directive

CRT Credit Risk Transfer

CSE Consolidated Supervised Entities

DBD Diversified Broker Dealer

EBDITA Earnings Before Depreciation Interest Tax and Amortization

EMIR European Market Infrastructure Regulation

EVA Economic Value Added

FATCA Foreign Accounts Tax Compliance Act

FDIC Federal Deposit Insurance Corporation

FRB Federal Reserve Board

FSA Financial Services Authority

FSB Financial Stability Board

FSCS Financial Services Compensation Scheme

FSMA Financial Services and Markets Act

G20 Group of Twenty

GAAP Generally Accepted Accounting Principles

GDP Gross Domestic Product

GSE Government Sponsored Entities

HIRE Hire Incentives to Restore Employment Act

IFRS International Financial Reposting Standards

IRS Internal Revenue Service

ISDA International Swaps and Derivatives Association

LCFI Large and Complex Financial Institutions

LMA Loan Market Association

LOLR Lender of the Last Resort

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LPFC Limited Purpose Financial Companies

MBS Mortgage Backed Securities

MiFID Market in Financial Instruments Directive

MMMF Money Market Mutual Funds

OLA Orderly Liquidation Authority

OTC Over the Counter

PECO Post Enforcement Call Options

RMBS Residential Mortgage Backed Security

SAR Special Administration Regime

SEC Securities and Exchange Commission

SIFI Systemically Important Financial Institution

SIFM Systemically Important Financial Markets

SIV Structured Investment Vehicle

SPV Special Purpose Vehicle

UCTIS Undertakings for Collective Investment in Transferable Securities

UNCITRAL United Nations Commission on International Trade Law

USC United States Code

V-a-R 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 Crédit 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. 08–1191 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 Statutes

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

P a g e | 66

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