The Value of Financial Market Insolvency Safe Harbours

Abstract

-'Safe harbour' is shorthand for a bundle of privileges in insolvency which are typically afforded to financial institutions. They are remotely comparable to security interests as they provide a financial institution with a considerably better position as compared to other creditors should one of its counterparties fail or become insolvent. Safe harbours have been and continue to be introduced widely in financial markets. The common rationale for such safe harbours is that the protection they offer against the fallout of the counterparty's insolvency contributes to systemic stability, as the dreaded 'domino effect' of insolvencies is not triggered from the outset. However, safe harbours also come in for criticism, being accused of accelerating contagion in the financial market in times of crisis and making the market more risky. This paper submits that the more important argument for the existence of safe harbours is liquidity in the financial market. Safe harbour rules do away with a number of legal concepts, notably those attached to traditional security, and thereby allow for the exponentiation of liquidity. Normative decisions of the legislator sanction safe harbours as modern markets could not exist without these high levels of liquidity. To the extent that safe harbours accelerate contagion in terms of crisis, which in principle is a valid argument, specific regulation is well suited to correct this situation, whereas to repeal or significantly restrict the safe harbours would be counterproductive.

Does the BRRD affect the retail banking business model in the Euro area?

“…In the EU, the change in legislation that paved the way for the development of those instruments is the European Financial Collateral Directive. Paech (2015, p. 15) argued that the risk mitigation techniques of master agreements are used to abolish established legal boundaries. In particular, the difference between full title and security interests disappears, because the safe harbour rules sanction the use of title transfer collateral, netting and margining.…”

“…In particular, the difference between full title and security interests disappears, because the safe harbour rules sanction the use of title transfer collateral, netting and margining. Furthermore, the collateral taker, who is the lender in the transaction, becomes the legal and beneficial owner of the asset and can therefore dispose of it without being obliged to return that specific asset (Paech, 2015, pp. 15–16).…”

“…It has been claimed (Paech, 2015) that the special status enjoyed by repo claimants will change with the introduction of the new resolution regime in the European Union. So far, the novelty it has introduced is that the early termination rights are suspended for 2 days right at the beginning of the resolution and afterwards, they are resumed only for those repos that remain on the balance sheet of the old (bad) bank, whereas those that are transferred to the new and supposedly healthy bank are not restored unless the new bank proves to be less healthy than it should be: “Even where master agreements provide for termination and close‐out upon reorganization or restructuring, resolution regimes eschew the route of privileged treatment through a safe harbour‐like mechanism” (Paech, 2015, p. 28). Thus, the same idea is more strongly stated: “Resolution regimes are more clear‐cut in this regard than insolvency laws.…”

“…Thus, the same idea is more strongly stated: “Resolution regimes are more clear‐cut in this regard than insolvency laws. There are no exceptions from the administrative stay comparable to safe harbour rules in insolvency law” (Paech, 2015, pp. 28–29).…”

Risk Management and Regulation

“…Also, they can immediately terminate their trades, collect collateral to cover insolvent counterparties' obligations, and become an unsecured creditor on the remainder. This special treatment has been questioned, particularly given financial institution resolution regimes introduced after the 2008 financial crisis(Paech 2016). 5 Affordability products included "hybrid" and "option" adjustable-rate mortgages requiring interest-only payment at fixed "teaser" rates that can result in negative amortization during the first few years(Kiff and Mills 2007).…”