The Principle Too Big to Fail Best practice

Bachir El NAKIB

Founder Compliance Alert 

The debate over "too big to fail" companies has been ongoing in recent years, particularly following the 2008 financial crisis and more recently, the collapse of Silicon Valley Bank (SVB) on March 10,2023. The term "too big to fail" refers to large financial institutions or corporations whose collapse would have a significant negative impact on the economy and the broader financial system. Some examples of companies considered too big to fail include JPMorgan Chase, Amazon, and Goldman Sachs, among others. However, it's worth noting that the definition can vary depending on the context and industry. Other companies that may be considered too big to fail include major airlines, telecommunications companies, and pharmaceutical corporations.

One major concern with these companies is the moral hazard associated with allowing them to be too big to fail. If they know they will be bailed out by the government in the event of failure, they may take on excessive risk, knowing they will not bear the full consequences of their actions. This creates a culture of recklessness and contributes to the buildup of systemic risk in the financial system.

The collapse of SVB is a prime example of this moral hazard. According to reports, the bank invested heavily in mortgage-backed securities, ultimately leading to its collapse. This investment trend was part of a larger trend among financial institutions in the mid-2000s, seeking to capitalize on the booming housing market. However, as the market began to collapse in 2007, these investments proved to be increasingly risky.In fact, the collapse of the housing market led to the failure of many large financial institutions, including Lehman Brothers, Bear Stearns, and AIG.

SVB's collapse serves as a reminder that too big to fail companies can still make risky investments leading to their collapse, despite their size and power. This highlights the need for continued regulation and oversight to prevent the buildup of systemic risk in the financial system. Despite its size and importance to the local economy, the company was unable to survive a run on its deposits. Undoubtedly, bailing out these companies prevents a complete financial meltdown but also creates a moral hazard thereby leading to a situation where institutions continue to engage in risky behavior, which has led to the SVB crisis as the mortgage-backed securities has proven to be a risky investment in time past, hence one would wonder why SVB would heavily invest in it again.

It is worth questioning whether too big to fail companies should be allowed to redefine the rules of capitalism. This may involve rethinking the government's approach to regulation and antitrust enforcement, as well as considering alternative economic models that prioritize competition and decentralization over consolidation and centralization of power. One of the key concerns is whether allowing these companies to exist and continue to grow, despite their potential negative consequences, is consistent with the principles of capitalism.

Capitalism is based on the idea that companies compete in a free market, and those that are successful are rewarded while those that fail are allowed to go bankrupt. However, when companies become too big to fail, the rules of the game change. These companies can engage in risky behavior, knowing that they will be bailed out by the government in the event of failure, which undermines the principles of capitalism.

Moreover, the existence of too big to fail companies can stifle competition and innovation, as smaller firms may struggle to compete with the dominant players. This can lead to a concentration of power and wealth in the hands of a few large companies, which may not be in the best interests of consumers or society as a whole.

The focus should shift towards preventing the formation of companies that are too big to fail in the first place, rather than relying on taxpayer-funded bailouts as a solution. This could involve breaking up large companies to prevent them from becoming too powerful and dominant, promoting competition and innovation. As a society, we need to ask ourselves whether allowing companies to become too big to fail is ultimately in our best interests and whether alternative economic models that prioritize competition and decentralization should be explored.

On one hand, bailing out these companies can prevent a complete financial meltdown and avert potentially catastrophic consequences for the broader economy. It can also protect jobs, prevent a ripple effect of bankruptcies, and provide stability to financial markets.

For instance when two of the world's by largest airlines - Lufthansa and Qantas were on the brink of bankruptcy, Lufthansa received a €9 billion bailout from the German government, which helped to prevent the airline from going bankrupt due to the massive decline in air travel during the COVID-19 pandemic. As part of the bailout, the German government took a 20% stake in Lufthansa and also imposed several conditions, including a ban on dividend payments and restrictions on executive pay. Similarly, in March 2021, the Australian government announced a A$1.2 billion bailout package for Qantas and other airlines, to help them recover from the impact of the pandemic on air travel. As part of the package, Qantas received a A$500 million loan from the government, which helped to secure its future and prevent it from collapsing. However, both Lufthansa and Qantas have pledged to repay the government loans and return to financial stability in the coming years. Lufthansa has already made significant progress in this regard, with the airline reporting a smaller loss in the first quarter of 2021 compared to the same period in 2020.

As a potential solution to address the issue of moral hazard associated with too big to fail companies. If a company that was considered too big to fail ends up failing, its credit rating should be reduced, and it should be subject to closer regulatory scrutiny to prevent it from posing a systemic risk to the financial system in the future and be stripped off the title of the “too big to fail”. This could help incentivize companies to avoid excessive risk-taking. Additionally, such a measure could provide greater accountability and transparency to prevent companies from relying on the assumption that they are too big to fail.

The debate over taxpayer-funded bailouts also raises important questions about the role of government in managing economic crises. While some argue that bailouts are necessary to prevent widespread economic damage, others argue that they encourage risky behavior and are unfair to taxpayers who are forced to foot the bill.

Ultimately, the best way to prevent companies from becoming "too big to fail" is to encourage competition and to create a regulatory environment that discourages risky behavior. This may involve measures such as breaking up large companies or imposing stricter capital requirements and oversight. However, even with these measures in place, it's impossible to completely eliminate the risk of economic crises and company failures.

Too Big to Fail and the USDOJ  enforcements

 

The U.S. Department of Justice and the New York District Attorney’s Office, together with the Office of Foreign Assets Control and federal and state bank regulators, have brought a number of cases in 2009 – 2010 against foreign financial institutions that clear dollar transactions through the United States involving prohibited entities and individuals under U.S. sanctions regulations. In the past, banks not subject to U.S. jurisdiction have generally avoided penalties under these regulations. The U.S. Government, however, has widened its enforcement to target financial institutions outside the U.S. for allegedly “causing” U.S. persons to violate U.S. sanctions regulations.

 

Deferred Prosecution Agreements and Settlements

Under deferred prosecution agreements, U.S. Department of Justice (DOJ) and New York District Attorney’s Office (NYDA) bring charges by filing a criminal information but agreeing not to prosecute the charges, provided the defendant complies with certain requirements outlined in the settlement. The requirements frequently include stipulating to the facts constituting the alleged violations, paying a monetary penalty, and instituting compliance procedures to prevent future violations. If the defendant abides by the terms of the agreement for a specified period, the charges are dismissed. Failure to comply with the agreement allows the DOJ and NYDA to proceed against the defendent on the basis of their prior stipulated facts.

 

Lloyds TSB Bank Plc. (Lloyds). Lloyds’ January 2009 deferred prosecution agreements with the DOJ and NYDA included a $350 million payment to settle allegations that Lloyds allowed Iran and Sudan to access U.S. financial institutions in violation of U.S. sanctions regulations and New York criminal law. Lloyds internally “stripped” customer names, bank names, and addresses from SWIFT payment messages to allow them to pass undetected through filters at U.S. correspondent banks. Had the messages contained transparent data concerning the parties, the U.S. correspondent banks would have been required to reject or block the transactions in compliance with U.S. sanctions regulations.

 

As part of the settlement, Lloyds agreed to employ an independent pre-approved consultant to review and report on five years of transactions. In addition, Lloyds agreed to comply with the Wolfsberg Anti-Money Laundering Principles for Correspondent Banking. In return, the DOJ deferred prosecution for two years and will subsequently dismiss the charges provided Lloyds remains in full compliance with the terms of the settlement.

 

In December 2009, Lloyds entered into a separate settlement with the Office of Foreign Assets Control (OFAC) agreeing to a $217 million fine, which was credited against the previous payment, and agreed to conduct annual reviews for two years of its policies and procedures and a “statistically significant” review of payments cleared through the United States.

 

Australia and New Zealand Bank Group, Ltd. (ANZ). In its August 24, 2009 OFAC settlement, ANZ paid $5.75 million to settle allegations of violations of the Sudanese Sanctions Regulations and the Cuban Assets Control Regulations. OFAC alleged that between 2004 and 2006, ANZ illegally processed 31 transactions through U.S. correspondent accounts totaling in the aggregate approximately $106 million. ANZ allegedly manipulated the SWIFT messages “stripping” them of any reference to Sudan or Cuba. ANZ’s actions concealed the identity of the sanctions targets and impeded U.S. financial institutions from identifying the restricted transactions.

 

OFAC agreed to mitigate the penalty based on three predominant factors. First, although ANZ did not voluntarily disclose the violations, ANZ cooperated in conducting an extensive review of the transactions and brought to OFAC’s attention additional transactions of which OFAC was not aware and which ANZ did voluntarily disclose. Second, ANZ promptly initiated a remedial policy. ANZ re-engineered its operating model to enhance its ability to identify and resolve operational gaps and weaknesses. ANZ agreed to continually audit its compliance model to ensure that future transactions that would be in violation of OFAC’s regulations are not processed by or through U.S. financial institutions.

 

The Australian Prudential Regulation Authority also agreed to monitor the results of ANZ’s internal review. Third, ANZ had not been subject to an OFAC enforcement action in the five years preceding the transactions at issue.

 

Credit Suisse AG (Credit Suisse). On December 16, 2009, DOJ, NYDA and OFAC announced a record-breaking $536 million settlement with Credit Suisse. The settlement documents alleged Credit Suisse’s involvement in thousands of concealed financial transactions with OFAC target countries processed through U.S. correspondent banks. Credit Suisse allegedly developed procedures to instruct clients on how to structure transactions and Credit Suisse altered payment paths and “stripped” payment messages of any reference to the target countries.

 

In addition to the fine, the settlement subjects Credit Suisse to a cease and desist order and requires implementation of a transparent global regulatory compliance program. The compliance program must include training for Credit Suisse employees on OFAC-related issues, an audit program designed to test for compliance, and an annual review of the compliance program by qualified personnel.

 

ABN Amro Bank N.V. (ABN AMRO)/Royal Bank of Scotland (RBS). In 2006, ABN AMRO agreed to a cease and desist order with OFAC and the Board of Governors of the Federal Reserve System. ABN AMRO was assessed a $40 million penalty, which also satisfied a concurrent $30 million FinCen penalty. The violations, which were voluntarily disclosed, involved ABN AMRO’s overseas branches, which removed references to entities in which Libya or Iran had an interest before forwarding wire transfers, letters of credit and U.S. dollar checks to ABN AMRO branches in New York and Chicago. This 2006 settlement, however, did not address criminal penalties.

 

On May 4, 2010, ABN AMRO, which had since been acquired by RBS, entered into a deferred prosecution agreement with DOJ agreeing to forfeit $500 million in connection with a two-count criminal information. Specifically, ABN AMRO waived indictment on one count of violating the Bank Secrecy Act and one count of conspiracy to defraud the U.S. by violating the International Emergency Economic Powers Act (IEEPA) and the Trading with the Enemy Act (TWEA).

 

The 2010 deferred prosecution agreement details a much broader pattern of violations. The factual statement accompanying the deferred prosecution agreement alleges that from 1998 through 2005, ABN AMRO conducted transactions valued at $500 million in violation of IEEPA, TWEA and the Bank Secrecy Act involving targets of U.S. economic sanctions and ignoring OFAC compliance obligations. ABN AMRO removed or altered names and references to target countries from payment messages. The “stripping” procedures allowed the transactions to pass undetected through filters at U.S. correspondent banks, where they would otherwise have been blocked and reported to OFAC. In addition to altering the payment messages, ABN AMRO failed to maintain adequate anti-money laundering procedures and processes.

 

ABN AMRO provided prompt and substantial cooperation, committed substantial resources to investigate transactions, and agreed to enhance its compliance policy to ensure transparency. In light of ABN AMRO’s remedial actions, DOJ agreed to recommend dismissal of the information in one year provided ABN AMRO continues to fully cooperate.

 

Policy Trends and Compliance Risks

These cases are a direct result of the United States’ policy to strengthen U.S. sanctions against Iran, as well as other countries, without explicitly requiring foreign financial institutions to comply with extraterritorial U.S. legal requirements. These cases also reflect a growing trend among enforcement agencies to cooperate on sanctions enforcement, bringing to bear not only the threat of higher monetary penalties but also heightened scrutiny from bank regulatory authorities and potential criminal fines and imprisonment. Regardless of the legal merits and possible defenses that may have been available, these institutions evidently decided to settle rather than face consequences that could have been even more serious.

 

A number of global financial institutions with headquarters outside the United States have adopted their own internal policies to comply with U.S. sanctions regulations as though they were U.S. institutions, judging that the risks of non-compliance and potential adverse impact on their business in the United States outweighed the risks of continuing to engage in business with countries targeted by U.S. sanctions.

 

The expanded reach of U.S. enforcement to activities that cause U.S. persons to commit violations within the United States presents a serious compliance risk. Financial institutions that clear dollar transactions through the United States must ensure that they comply with U.S. sanctions regulations.

Bachir A. El-Nakib

"Knowledge is the only treasure that increases on sharing