I take your hypothetical scenario of counterparty failure, and raise you a bank resolution regime... Imagine spending an entire career evaluating bad things that might happen to financial institutions. It's no mere thought experiment done in passing, but rather a task that one slaves over in excruciating detail. For years upon years on a constantly moving chessboard of potential disaster. So, who wants to be a regulator? Applicants can expect to look for threats around every corner, and impose requirements to hold specific amounts of capital in case certain bad things actually do happen - property prices tank, interbank lending dries up, ratings plummet, governments restructure their debt, and counterparties fail. This all seems fine, and a lot like what risk functions in banks would themselves do, but this is Alphaville and we haven't gotten to the "excruciating detail" yet. Take it away, Boromir: Where hypothetical scenarios meet reality, there you shall find regulation, and we recently came across a particularly intriguing, and potentially costly, imagined situation. To put oneself in the appropriate mindset for what comes next, consider capital calculations for repo, stock lending, and derivatives transactions where one of the counterparties is a bank in the Netherlands. Got it? In general, one is allowed to net such transactions - within their respective categories - when calculating regulatory capital, particularly when governed by the same (master) agreement. The difference between the gross and net figures can be rather large. To quote a 2010 paper published by the International Swaps and Derivatives Association: Close-out netting has reduced over-the-counter derivatives credit exposure by over 85 percent; without the benefits of netting, banks worldwide might face a capital shortfall of over $500 billion. Netting, however, can be subject to legal disputes, as its effectiveness hinges on how contracts are drawn up and the laws that enforce the provisions of said contracts. Given all of that, regulators require the following under Basel II: ...a bank will need to satisfy its national supervisor that it has... Written and reasoned legal opinions that, in the event of a legal challenge, the relevant courts and administrative authorities would find the bank's exposure to be such a net amount under: The law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located; The law that governs the individual transactions; and The law that governs any contract or agreement necessary to effect the netting. The national supervisor, after consultation when necessary with other relevant supervisors, must be satisfied that the netting is enforceable under the laws of each of the relevant jurisdictions; (iii) Procedures in place to ensure that the legal characteristics of netting arrangements are kept under review in the light of possible changes in relevant law. "Procedures" typically mean getting a legal opinion - one per jurisdiction - updated every year that discusses whether netting would be upheld if challenged in the court of said country. The answer usually being along the lines of "yes, netting should hold" - after a few hundred incredibly expensive pages. It'd be a lot of work, getting all those opinions, so thank goodness for industry bodies like ICMA and Isda - they collect the opinions and distribute them to members. The latest opinion for the Netherlands, with respect to the Global Master Repurchase Agreement (for repos) and Global Master Securities Lending Agreement, raised some red flags where previously no such flags had been. We expect that the opinion about Isda Master Agreements will be similar, though we haven't seen it (but we'd love to, and here's a way to reach me anonymously). The red flag is a consequence of the rather hastily drawn up Dutch Intervention Act that came into force in June 2012. "Hasty" because the clock was ticking for SNS Reaal, which was ultimately taken over by the state earlier this year using powers granted by the Act. Over to said legal opinion, as written by law firm NautaDutilh: The Intervention Act does not explicitly provide for protection of certain creditors and/or certain contracts or other arrangements, such as transactions that are part of a single (master) agreement or secured liabilities. It is therefore conceivable that, for instance, a partial-transfer plan provides for the transfer of some but not all Transactions under an Agreement between a problem institution and another party. Ohh, whoops, the Dutch can hypothetically break netting sets. It is just a hypothetical, but as discussed above, that's kinda what most of regulation is. Also, we note that this particular hypothetical has been known for at least a year, though why it hasn't been discussed more seems a little strange to us... Continuing with the opinion to something that might make it all better: Of course, if the plan would be to the detriment of the latter (as a remaining creditor of the problem institution) or to other remaining creditors, the court should not approve it. Phew, the court might not approve a break up of netting sets after all. Just kidding! Not that easy to escape unscathed: However, in practice creditors and other interested parties will not be aware of the preparation of the plan and the court proceedings (which are not public in any case), while they have no right to appeal or otherwise object against the court approval of a transfer plan (only the problem institution itself and its shareholders have such rights). Be very, very quiet, we're resolving a troubled bank... In addition, it is unlikely that the court will have sufficient time to be able to scrutinise the plan laid before it in much detail. And we're doing it fast. We bet we know what some of you clever clogs are thinking, and the answer is either "no" or "not without much pain." Again, from the opinion: Interventions by authorities at a Bank or an Insurance Company may constitute an event of default, termination event or similar event under their contracts with counterparties, giving rise to termination or other rights of these counterparties. Since the unrestricted exercise of such rights is considered undesirable in the event of intervention, the core provisions [of a part of the Invention Act] stipulate that: (i) counterparty rights against a Bank, an Insurance Company... cannot be exercised (except with the consent of the DNB), to the extent that those rights are triggered by an "event..." But it's likely too late to try to get out of said contract anyway by the time a netting set is broken (see above about the no-appeals, quick and non-public nature of the resolution process). Back to Basel II, the question that must be again raised is: We talked to Prof.dr. W.A.K. Rank, a partner at the firm that wrote the opinion, and he took a rather pragmatic stance about it all: The technical flaw in the Dutch Intervention Act is that it lacks explicit safeguards for master agreements like the GMRA (Global Master Repurchase Agreement) and GMSLA (Global Master Securities Lending Agreement). This means for instance that the Dutch Central Bank (DNB), when applying intervention measures, could - theoretically - choose to separate transactions under a single master agreement between a bad bank and a good bank... We understand from the Dutch Ministry of Finance (MoF) that this possibility was never foreseen, let alone intended. Furthermore, the Dutch Intervention Act provides that intervention measures require court approval, and that a court may not approve intervention measures that are to detriment of the relevant financial institution's creditors. It therefore seems very unlikely that intervention measures will in fact result in single master agreements not being respected and that close-out netting of transactions under a master agreement would not be enforceable as a result thereof. So maybe one is satisfied by "very unlikely"? In the end: ...it is up to the legal opinion reviewers, and market parties and their regulators, to make their own independent assessment of the situation. In our view, the concerns are mostly theoretical and should therefore be gauged properly. Everyone involved needs to make up their own mind about how this particular hypothetical should affect regulatory capital holdings, but damn would it get expensive to transact with Dutch banks if a counterparty couldn't net for regulatory capital purposes. It'd be much nicer for all concerned if the Dutch government would play ball and fix the problem, rather than having to wait for the new EU-wide system for resolution that will - eventually - make the problem go away. As Prof.dr. W.A.K. Rank notes: It is however still preferable that master agreements are explicitly protected, preferably through inclusion of firm safeguards in the Dutch Intervention Act. We understand that laws similar to the Dutch Intervention Act, for instance in the UK or Germany, do explicitly protect master agreements. Similar safeguards will furthermore likely be included in the future EU Recovery and Resolution Directive (RRD). Dutch banks are in dialogue with the MoF [Ministry of Finance] to see how the technical flaw can be repaired. In this respect, they are looking closely to legislation in other European jurisdictions and the RRD. Just another day in regulation. Related links: The Netherlands adds "slow-motion bank wrecks" to list of things it's known for, right after "clogs" and "windmills" - FT Alphaville Deal with failed banks the Dutch way: rely on the ECB, deposit insurance, and the public's faith in the government - FT Alphaville Do you believe in netting, Part 1 and Part 2 - FT Alphaville