Change font size:   

 
No. 6: If you don’t give it to me you’ll only lend it to someone else and look where that got us

No. 6: If you don’t give it to me you’ll only lend it to someone else and look where that got us

10 reasons to tell your boss you deserve a bonus

Bank deleveraging has barely started

Bank deleveraging has barely started

Banks lending money to governments to help fund bank bailouts looks horribly circular

weeklyFiXLiquid real estate
Skip Navigation LinksHome :: Back Issues :: Slipping through the net

January 1996

Slipping through the net


Netting makes bankers' eyes glaze over. But close-out netting can make them money. By Christopher Stoakes.




If bank A and bank B enter into a criss-cross of foreign exchange or derivatives transactions, it makes sense for them to agree to tot up what each owes the other and for the balance - the net amount, rather than the gross - to be paid over by one to the other. This is payment netting. It reduces the delivery exposure to each party by substituting net for gross amounts. It cuts transaction costs by reducing payment flows and cross-currency conversions.

But the reason why bankers are keen on netting is because a variation, called close-out netting, has recently been recognized as effective for capital adequacy requirements and US accounting rules. This means that bankers can report their risk net rather than gross, thereby reducing the capital attributable to each transaction. The bank's cost of capital is reduced and it can take on more business.

The only decision then is what form of master agreement to enter into with counterparties. One is the International Foreign Exchange Master Agreement (Ifema) which is sponsored by the British Bankers' Association (BBA). The other is the Isda (International Swaps and Derivatives Association) model. Ifema is generally regarded as the simpler and therefore better document, but it covers only foreign exchange (FX) transactions. The Isda agreement, by contrast, has the benefit of being a multi-product document, which is why it is more complicated. But it just requires an FX addendum to do what the Ifema document does. Your choice depends on whether your counterparties deal in swaps and derivatives, or simply trade in FX. If they just do FX, they are better off sticking to the Ifema agreement.

Netting can be tricky and tedious because it embraces two subjects dear to lawyers' hearts - insolvency and conflict of laws. Insolvency because the attempt by banks A and B to net their positions will really be tested if one of them goes bust; and conflict of laws because the chances are that A and B are international banks in different countries, so their attempts to net successfully will depend on the insolvency laws of the defaulting party.

The courts of some countries - principally those with a civil law system such as Spain's - are hostile to the idea that netting should deplete the pool of assets available to the rest of a bust bank's creditors, and their courts could ignore the netting agreement completely. A may be obliged to continue making payments without any prospect of bankrupt B doing the same. If that happens while A is blithely assuming - and reporting to the regulators - that its positions with B are being met, A could collapse too. A and B may specify that their agreement is to be governed by the law of a sympathetic jurisdiction. Whether that choice is upheld will itself vary from jurisdiction to jurisdiction. "Once one descends to that level of detail," says a netting specialist in the legal department of a US bank, "the possibility for voluminous analysis is endless."

For this reason, bodies such as the Basle Committee on Banking Supervision have recommended that netting should be recognized only if it is backed by legal opinions showing that the netting agreement is effective in all relevant jurisdictions. In a sense, all jurisdictions are likely to be relevant in the context of international banking, which is why Isda and BBA have been collecting legal opinions from around the world.

To make the task manageable, the regulators have specified that the relevant jurisdictions in bank A's case means the laws of the country where B's head office is located, and the country where, if A is dealing with a branch of B, that branch is located. Also relevant are the laws governing the individual transactions to be netted and the netting agreement itself. This can still be complicated where A and B want to enter into a multi-branch master agreement. "You need compatibility of treatment between jurisdictions," says David McCarthy, an international finance partner at Cameron Markby Hewitt. "Even in Italy, for example, opinions conflict over whether the courts will accept close-out netting."

Clifford Chance has carried out a comparison of the effect of insolvency law on netting in 10 key jurisdictions. The results are not uniform. Key questions include whether B's liquidator can cherry-pick (choose which agreements to keep and which to treat as terminated), whether a clause providing for automatic termination is necessarily desirable, and whether retrospective termination (as provided for in the Isda agreement) works. One type of provision, called a walkaway clause, would seem ideal. It says that, if B defaults, A can still require payment of its loss while not being bound to pay over any gain on termination. However, the regulators do not like such clauses and, if they see one in a contract or master agreement, will withhold the regulatory benefits of netting.

All of this assumes, of course, that A and B are close-out netting. By contrast, payment (or settlement) netting does not change the underlying gross obligations and cannot be used cross-currency. For these reasons, it is inadequate to obtain regulatory recognition. It simply means that, on the due date, amounts in the same currency can be netted off and only the balance changes hands.

The third version, netting by novation, does alter the underlying gross obligations. Novation occurs when a new contract, which replaces an old one, comes into being. As A and B enter into successive transactions, the gross obligations are replaced by the net position. This is treated as effective by regulators but, like payment netting, it only affects payments in the same currency due on the same date. "Netting by novation is a misnomer. It is really payment netting in advance," says derivatives partner Schuyler Henderson at Baker & McKenzie. "You don't wait until the payment date to net but do so each time you enter into a contract which creates a fixed monetary obligation on the given date where this is reverse obligation in the same currency." By contrast, close-out netting cuts across all currencies and concertinas all deals. "It is a valuation of future cash flows, not of liabilities currently payable," says Henderson.
   Page 1 of 2  Next | Single Page






Bear market: Eight months when the kids get no allowance, the wife gets no jewellery and the husband gets no sex

Top 10 financial definitions that are funnier since the credit crunch

  1. US treasury market reaches breaking point

  2. US equity market – Fails to deliver: The naked truth

  3. Top 10 financial definitions that are funnier since the credit crunch

  4. Top 10 reasons to tell your boss you deserve a bonus this year

  5. Eksportfinans turns to government for funding

Latest Issue

December 2008
Ruromoney Jobs Post a job

Home | Mobile site | Contact Us | Debt markets | Equities | Foreign exchange | Banking | Alternative Investments | Regions and Emerging markets | Polls & Awards | Structured credit | Back issues | Euromoney store | Useful links and Related events | Site Map

The material on this site is for financial institutions, professional investors and their professional advisers. It is for information only. Please read our Terms and Conditions, Privacy Policy before using the site.

All material subject to strictly enforced copyright laws. © 2008 Euromoney Institutional Investor PLC.