Senate Banking, Housing and Urban Affairs Committee

Subcommittee on Financial Institutions


Hearing on S.958
"The Financial Institutions Insolvency Improvement Act of 1999"


Prepared Testimony of Mr. Don Thompson
Vice President & Assistant General Counsel
J.P. Morgan & Company, Inc.


9:30 a.m., Wednesday, May 5, 1999

Mr. Chairman, I am Don Thompson, Vice President and Assistant General Counsel of J.P. Morgan & Co., Incorporated. I have represented J.P. Morgan in its full range of derivatives activities since 1987. In this capacity, I have overall responsibility for reviewing the legal enforceability of derivatives contracts, including enforceability of contract netting provisions. J.P. Morgan is one of the world's largest derivatives dealers and has been active in the global derivatives markets as an end user and dealer since 1985. J.P. Morgan makes markets in derivatives related to the interest rate, foreign exchange, equity, commodity and credit markets globally and, as of the end of 1998, had outstanding derivatives contracts with notional amounts in excess of $5 trillion.

I am also an active participant in various industry trade associations specifically targeted to derivative activities, including the International Swaps & Derivatives Association ("ISDA") and the American Bankers Association's securities affiliate, ABASA. In these capacities, I have participated extensively in drafting netting agreements that serve as industry templates, reviewing legal opinions relating to netting, and otherwise educating our industry and other interested parties about derivatives transactions and the benefits associated with netting. It is on behalf of the ABA(1) and ABASA(2) that I appear here today, Mr. Chairman.

Mr. Chairman, I commend you for holding this hearing on the need to update bank insolvency laws, particularly as those laws apply to the treatment of swap agreements, repurchase agreements, securities contracts and other similar financial instruments. The issues under consideration by this Committee are very important to J.P. Morgan, to the membership of the ABA and ABASA, and to the derivatives market as a whole.

Commercial banks use derivative instruments both as end users and as dealers. As end users, commercial banks, much like other corporations, generally use derivative instruments to manage their own institution's risks and reduce funding costs, thereby enabling them to make credit more widely available in their local communities. It is estimated that approximately 450 banks used derivative contracts in 1998.

Many of ABASA's members, including my own organization, along with non-bank broker-dealer affiliates and other commercial firms, also serve as derivatives dealers, capitalizing on, among other things, their ability to understand the financial needs and risk management objectives of their many customers. Dealers generally do not charge fees for arranging these transactions; rather their profits are earned from spreads between the bid and offered prices on derivatives.

As both end users and dealers, commercial banks are subject to the insolvency provisions of the FDIA while non-bank participants are subject to the Bankruptcy Code. Congress has previously recognized the importance of having all participants in the derivatives markets operate under insolvency regimes that are consistent. To that end, the FDIA has been amended several times in the past to reduce inconsistencies between the insolvency provisions of the FDIA and the Bankruptcy Code.

The ABA and ABASA urge the Committee to amend the Federal Deposit Insurance Act ("FDIA") to provide greater certainty regarding the types of financial contracts eligible for netting and to explicitly permit eligible counterparties to net exposures across different types of financial contracts. Similar amendments to the Bankruptcy Code were recently approved by the Senate Committee on the Judiciary.

The amendments suggested today are largely based upon the proposals previously suggested by the President's Working Group on Financial Markets. Only last week that group reiterated its support for these amendments in its report to the Congress entitled Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management.

As the Committee has recognized, the amendments advocated herein have two principal purposes:

To strengthen the provisions of the FDIA that protect the enforceability of acceleration, termination, liquidation, close-out netting, collateral foreclosure and related provisions of financial agreements and transactions, and

To harmonize the treatment of these financial agreements and transactions under the Bankruptcy Code and the FDIA.

Mr. Chairman and members of the Committee, the need for these amendments is real.

Innovation in the markets has created ambiguities as to whether certain types of instruments fit within the categories of instruments defined in the FDIA as eligible for netting. These ambiguities need to be addressed. As the Committee is well aware, netting is important because it enables parties to these transactions to reduce both their risk exposure to individual counterparties as well as their aggregate risk exposure. In reducing exposures, counterparties also reduce systemic risk, i.e., the likelihood that one counterparty failure will contribute to the failure of other market participants and eventual financial market disruption.

The credit derivatives market provides an excellent example of a market where innovation and legitimate risk management practices are hampered by a lack of legal certainty concerning the netting treatment of credit derivatives under the Bankruptcy Code and the FDIA. This lack of legal certainty has resulted in some of J.P. Morgan's clients declining to enter into legitimate risk management transactions linked to credit because of the lack of certainty that their exposure to Morgan under those credit-linked transactions could be netted and offset against other derivative transactions with Morgan.

Without legal certainty, innovation can be stifled and the U.S. capital markets and participants placed at a competitive disadvantage to other countries that broadly recognize and give effect to netting provisions.

Amendments to the FDIA are also needed to remove legal uncertainties with respect to the ability of market participants to net one type of exposure (e.g., under repurchase agreements) against another type of exposure (e.g., under swap agreements) under a so-called "master netting agreement." Cross-product netting reduces systemic risk and improves liquidity in the markets for these financial instruments.

By approving the proposed amendments to the FDIA, the process begun in previous Congresses of ensuring consistency between bank insolvency laws and the Bankruptcy Code will continue unabated. Consistency between the insolvency laws as they apply to all counterparties, bank and non-bank alike, will extend the benefits of netting to all market participants and maximize its benefits for our economy as a whole.

In conclusion, we strongly urge the Committee to approve the proposed amendments to the FDIA and look forward to early consideration by the Senate. Thank you.



Notes:

1. The ABA brings together all categories of banking institutions to best represent the interests of this rapidly changing industry. Its membership ­ which includes community, regional and money center banks and bank holding companies, as well as savings associations, trust companies and savings banks--make ABA the largest banking trade association in the country.

2. ABASA is a separately chartered trade association of the American Bankers Association, formed in 1995 to develop policy and provide representation for those bank holding companies involved in, among other things, securities underwriting and dealing and derivatives activities.


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