Schemes with LDI strategies should review counterparty creditworthiness, say pensions lawyers, as a new EU directive has granted national authorities the power to suspend schemes’ contractual rights with struggling banks.
In the aftermath of the global financial crisis G20 leaders came together to review resolution regimes and bankruptcy laws following the collapse of the ill-fated Lehman Brothers.
The European Bank Recovery and Resolution directive is the regulatory response to post-crisis insolvency risk and was adopted by the EU in May 2014.
From a pension fund trustee perspective it’s probably a headache they don’t want to have but that’s just going to be the reality of trading with [these] institutions
Doug Shaw, Linklaters
The directive was implemented in the UK in January this year but pensions lawyers say little attention has been paid to the potential impact on schemes’ derivative programs.
Bail-in
When a bank fails it may go into bail-in, a process which awards emergency powers to a national resolution authority to stabilise the failing structure.
Bail-in is conducted by the resolution authority using the bank’s own resources, namely the interests of existing shareholders and counterparty contracts.
Agreements can be cancelled, diluted or transferred and the claims of unsecured creditors written down to minimise losses to the bank.
Therefore, if a bank goes into bail-in in the UK the Bank of England assumes the power to close out and terminate the bank’s derivative contracts without counterparty consent.
Resolution authority powers
As a resolution authority, the Bank of England also has the power to:
Value the termination amounts owed by the bank to its counterparties under derivative contracts
Suspend counterparties’ termination rights
Apply a haircut to the amount owed to counterparties by writing down the liabilities
According to Clifford Sims, partner at law firm Squire Patton Boggs, the Bank of England's emergency resolution powers would override any contractual protection that pension funds as counterparties might have thought they had.
However, Sims said trustees do have some tools at their disposal to mitigate the risk of contracts being terminated.
“[Schemes] should routinely be conducting ongoing checks of creditworthiness and diversifying counterparties to reduce concentration risk,” he said, adding: “Regulatory guidance from the European Banking Authority goes further by suggesting market participants should increase their due diligence on banks’ risk profile and management practices, which is perhaps easier said than done.”
Doug Shaw, senior lawyer at law firm Linklaters, said bail-in procedures only affect the net position underlying schemes' derivative contracts.
He said: “It’s only the net sum that ends up susceptible to bail-in.
“If you’re in the normal world where you’ve got a collateralised trade then your close-out amount should be quite small if your collateral has done its job properly.”
He added: “From a pension fund trustee perspective it’s probably a headache they don’t want to have but that’s just going to be the reality of trading with [these] institutions."
Arron Slocombe, partner at law from Baker & McKenzie, said the implications of the directive could have an impact on trustees’ choice of counterparty.
In practice, Slocombe said trustees should close out transactions with struggling counterparties.
“It’s probably a good thing to get out and get out early,” he said.
“[Trustees] can then put hedges in place to replace the old one if they need to – that’s much better than being locked in.”
