Compensation of credits and key attributes

Luiz Alfredo Paulin 21/10/2020

Brazil has historically adopted very effective prudential regulations and resolutive rules for financial institutions. Partially as a result of these rules, international financial crises have been less damaging in Brazil than in many other markets.

The 2008 crisis shed light on some of the vulnerabilities of national markets, particularly in relation to the existence of financial institutions deemed to be “too big to fail”. In addition to threatening market stability, these entities put taxpayers' money at risk. To address these vulnerabilities and avoid future crises of this scale, the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system, was tasked with proposing solutions to minimize systemic risks in financial markets worldwide.

In 2011, the FSB proposed a standard framework for resolution regimes through the document called Key Attributes of Effective Resolution Regimes for Financial Institutions. The implementation of this regime at a national level was expected to reduce the exposure to risks derived from the insolvency of financial institutions, particularly the largest ones.

Although already compliant with some of the FSB’s key propositions, the Central Bank of Brazil drafted a Bill of Complementary Law (PLP No. 281/2019) aimed at changing the resolution regimes of financial institutions, capital markets institutions, insurance companies, private pension entities and financial market infrastructure operators. The bill provides for two possible resolution regimes: mandatory extrajudicial liquidation and stabilization (a kind of special administration regime).

Given that the draft bill is still being debated in Congress, it is likely that different stakeholders will propose amendments before it is finally put to a vote. One of the provisions which is expected to be most controversial is the authorization of compensation (or netting) of debts and credits against institutions subject to the resolution regimes, provided in Articles 31, I, and 57, 2nd paragraph, of the draft bill. Critics of the bill argue that the compensation violates the equality among creditors as it allows creditors that are also debtors of the institution subject to a resolution regime to be paid before other creditors.

However, a significant part of the transactions carried out in the financial and capital markets are structured to be always settled through compensation. Typical examples are derivative transactions and “two-point box” transactions (simultaneous purchase of identical quantities of purchase and sale options over a security or index). Also, credit transactions, whilst not ordinarily settled though compensation, often benefit from lower interest rates if the bank has the possibility to set off unpaid amounts against deposits held by the client.

For this reason, we believe that the inclusion of compensation provisions in the bill of law prepared by the Central Bank of Brazil is a positive development and should be kept. If compensation were not admitted in the final text of the law, one could expect that many transactions would cease to be carried out by financial institutions or would be done at a much higher cost.

In a scenario where compensation is not possible, the enactment of an institution's resolution regime – particularly if affecting an institution deemed to be “too big to fail” – would completely disrupt the market. This is because transactions carried out in the financial and capital markets are heavily interconnected. The failure of a large number of transactions – which would inevitably occur if the regime were enacted in relation to a large institution – would lead to a totally undesirable cascade effect.

Increasing the risk of market disruption is contrary to the main objective of the draft bill, which is to preserve market stability and ensure swift market operation. Therefore, it is of utmost importance that the National Congress maintains the provisions that authorize the compensation of debts and credits against financial and other institutions subject to resolution regimes.

L&S Authors

Luiz Alfredo Paulin

Luiz Alfredo Paulin

Of Counsel

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