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Capital Markets Law Journal, Vol. 6, No. 4

Central bank collateral and the Lehman collapse

Christian Hofmann*

Key points

1. Outline
The Lehman collapse has gone down in history as the peak of the latest financial crisis.
The markets were already in uproar when Lehman Brothers Holdings Inc. (LBHI) and
several other Lehman core US entities filed a petition for bankruptcy protection under
Chapter 11 of the US Bankruptcy Code on 15 September 2008. The holding company
held the stocks of numerous subsidiaries which operated in different national markets,
some of which were holding companies for further subsidiaries. Lehman Bancorp. Inc.
provided mortgage and retail banking services through its subsidiaries in the USA. In the
UK, Lehman operated mainly through Lehman Brothers International Europe Ltd, and
in Germany through Lehman Bankhaus AG Frankfurt, which held a full banking
licence under German law and was fully owned by LBHI. As a result of the holding
companys petition for bankruptcy protection, the German subsidiary was placed under a

*Dr Christian Hofmann, LL.M.oec.int. is a Senior Legal Counsel at Deutsche Bundesbank and Lecturer (Privatdozent) at
Humboldt University at Berlin. The views expressed are those of the author and do not necessarily reflect those of the
Deutsche Bundesbank.
The Author (2011). Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oup.com


Accepted 22 August 2011

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 The major source for credit institutions to satisfy their need for liquidity is the open market business
of the central banks. Euro refinancing is provided by the national central banks of the Eurosystem.
This system has drawn interest in two scenarios.
 Currently, the sovereign debt crisis has led to major downgrades of the sovereign bonds of some euro
area member countries. This development has raised the issue whether the Eurosystem should amend
the rules on collateral for credit operations.
 Earlier, the Lehman collapse challenged the underlying rules and led to significant changes.
 The Lehman collapse has been relevant in the field of litigation: investors in Lehman certificates lost
their investments in the wake of the Lehman collapse. The courts have so far ruled differently on their
claims for damages.
 This article explains the principles of the Eurosystem collateral regime. It further describes the issue of
the Lehman collapse for the Eurosystem, the changes that have resulted from the event and reflect
whether further adjustments to the requirements seem necessary. It also describes briefly the effect of
the Lehman collapse on litigation in Germany.
 The article provides the necessary background information to understand the significance of the rating
of assets for their eligibility as Eurosystem collateral. It also offers a brief outline of the duties of the
providers of investment services towards investors.

Christian Hofmann  Central bank collateral and the Lehman collapse


2. On a side note: losses by private investors

Private investors in Germany bought certificates issued by a Dutch member of the
Lehman group, the Lehman Brothers Treasury Co. B.V. After the collapse of Lehman,
these investors are left with claims against an insolvent company and potential claims
against the providers of investment services based on breach of duty. A substantial
number of investors claim that the services providers neglected their duty to declare the
various risks of these certificates and were also in breach of their duty to act in the best
interest of the investors, and pursue these claims in court.
The relevant legal regime
Under German law, the claims of harmed investors depend on the legal nature of the
duties of providers of investment services. The statutes created to implement the
requirements of Article 19 Markets in Financial Instruments Directive (MiFID)2 are a
major source to determine the content of these duties. The majority opinion, above all
the Federal Supreme Court (Bundesgerichtshof), interprets these statutes as public law
and, as a result, applies them to the relationship of the supervisory authorities enforcing
these rules and the investment services providers. The breach of these duties per se does
not constitute grounds for the injured partythe investorto claim damages from the
services provider.3 Instead, those claims depend entirely on the regime for private law
1 On the German subsidiary in more detail in Section 4.
2 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments
amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council
and repealing Council Directive 93/22/EEC, OJ 2004, L 145/1.

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supervisory moratorium.1 Lehman Brothers International Europe Ltd. filed for administration under English insolvency law.
The insolvency of core entities of the fourth largest investment banking group sent
shockwaves around the world. It led to a liquidity crunch that impressively proved the
risk of contagion in the financial world and, in reaction thereto, led the central banks to
flood the markets with liquidity. From that perspective, it even had its share in the
following world economic recession and the current sovereign debt crisis. Further
consequences affect private investors. They had bought certificates issued by Lehman
which led to irrecoverable claims. As a result, the courts have been ruling on numerous
suits by investors in Lehman bonds against investment service providers for insufficient
information and inaccurate advice (to be discussed further in Section 2). What is more,
the Lehman collapse has directly affected the Eurosystem. Like many other banks,
Lehman participated in the open market, refinancing operations of the Eurosystem.
Loans were given to Lehman in exchange for collateral. When Lehman became insolvent,
the Eurosystem was left with the collateral to satisfy its claims. The issues that arose
indicated that the eligibility criteria of the Eurosystem for open market collateral did not
reflect all risks, which became apparent in the Lehman crisis and therefore led to
amendments. This is the focus of this article and will be discussed in Sections 3 and 4.


Capital Markets Law Journal, 2011, Vol. 6, No. 4

The court decisions

When deciding about claims resulting from the Lehman collapse, the German courts
follow the described system. The investors mainly pursued three approaches.
1. First, the investors alleged that the risk of a collapse of Lehman was obvious and that
the investment services providers were therefore obliged to abstain from recommending the certificates to their investors. Some courts pondered these allegations and
analysed the issue of whether reports about the worsening situation on the US housing
market and the rising number of foul credits should have resulted in warnings that US
based banks heavily involved in the trading of house loan based asset-backed securities
(ABS) ran a high risk of becoming insolvent. Yet, the courts have concluded that this
danger was too vague to produce any duty to inform or even refuse the transaction.6
This seems well justified. The situation immediately before the Lehman collapse was
one of imminent dangers for the world economy. From a perspective ex post we know
that practically the whole financial sector and wide parts of the economy were
3 Judgment of the Federal Supreme Court (Bundesgerichtshof) of 19 February 2008XI ZR 170/07.
4 Judgments of the Federal Supreme Court (Bundesgerichtshof) of 6 July 1993XI ZR 12/93, and of 22 March 2011XI ZR
5 Art 19 MiFID was implemented by s 31 WpHG.
6 See the judgment of the appellate court in Frankfurt (OLG Frankfurt) of 17 February 201017 U 207/09 emphasizing the fact
that the assumption that major financial institutions would receive the necessary support from the governments was justified. The
appellate court in Dusseldorf points out that the rating of Lehman was within the margin of a so-called investment grade until the
day it filed for insolvency, judgment of 16 December 2010I-6 U 191/09.

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liability and therefore the principles on breach of contractual obligations and torts. The
German courts rule on the grounds of precedence decided by the Bundesgerichtshof
before the MiFID was enacted and its requirements implemented.
The essential points are: if the investor signals to the investment services provider his
need for advice on an investment, the two parties are deemed to enter into a contractual
relationship which requires the provider to disclose relevant information to the investor.
The provider is obliged to ensure that the investment is in line with the investors
pursued investment purpose, that the investor has understood the relevant aspects of the
investment and that he is capable of deciding in his own best interest. What is more, the
provider must have the best interest of the investor in mind and avoid any conflict of
interest.4 These obligations go beyond even the requirements of Article 19 MiFID.5
In other cases where the investors instruct the investment services providers to solely
execute their orders (execution only), the strict regime does not apply. The courts,
however, find certain contractual duties in these cases as well. They are less strict but still
require the provider to evaluate the investors level of experience, the level of riskiness of
the investment and, resulting from these steps, may oblige the provider to inquire about
the investors intentions and issue warnings where the investment seems inappropriate.
Here, the courts indirectly apply the requirements of Article 19 MiFID. The contractual
duties owed to the investor are defined by the standards expressed in the statutes
implementing the MiFID.

Christian Hofmann  Central bank collateral and the Lehman collapse


3. The open-market business of the Eurosystem

These claims by private investors who bought certificates issued by Lehman are not in the
least linked to another issue arising from the Lehman collapse, the realization of assets
7 On deposit guarantee schemes see the latest proposal of the Commission, Proposal for a Directive. . ./. . ./EU of the European
Parliament and of the Council on Deposit Guarantee Schemes (recast), COM(2010)368.
8 District Court of Hamburg, judgments of 23 June 2009310 O 4/09 and of 1 July 2009325 O 22/09.
9 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments
amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council
and repealing Council Directive 93/22/EEC, OJ 2004 L 145/1.
10 Judgment of the appellate court in Frankfurt (OLG Frankfurt) of 17 February 201017 U 207/09; judgment of the regional
court in Frankfurt (LG Frankfurt) of 7 April 20092-19 O 211/08.

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threatened by the signs of a burst of the US housing market bubble and its various
consequences. However, until 2008 only companies with high exposure in the US
housing market were considered severely threatened. Only later did it become clear
that those risks had been collectivized by integrating them into ABS and Collateralized
Debt Obligations (CDOs) which had found investors all over the world. With a high
amount of distrust dominating the markets, any financial investment posed a potential
risk. From this it can be concluded that it was hardly obvious for the investment
services providers that Lehman was one of the riskiest debtors in the world given that
its rating by the major rating agencies was still above investment grade. It seems,
rather, that others could have shared Lehmans destiny or even taken its placegiven
that Bear Stearns, Fannie Mae and Freddie Mac had been bailed out before and
numerous other financial institutions and big companies were rescued afterwards.
2. The second line of the argument focuses on the failure to inform that the claims
underlying the certificates were not secured by deposit guarantee schemes.7 One court
actually granted damages to the investors on the grounds that the brokers did not
explicitly warn them about the fact that certificates are different from deposits and
therefore do not benefit from deposit guarantee schemes.8 It based this on the
assumption that inexperienced investors were ignorant of the difference between
certificates and deposits. These decisions stand since they have not been appealed. It
can, however, be predicted that this line of judgment will hardly find approval from
legal commentators. Taken further, the judgment would mean that brokers have to
issue a similar warning in a multitude of cases, including the purchase of shares or
(sovereign and other) bonds.
3. The third approach focuses on the complexity of the certificates and analyses whether
the investment services providers met the requirements of Article 19 MiFID.9 The
courts examined the complexity of the product and the need of the individual investor
for information and advice. In a number of cases the courts considered the certificates
highly complex and held that the investors were inexperienced. On that basis, they
granted full compensation.10 Legal commentators may criticize this reasoning as well.
It is evident that the complexity risk was not the real cause for the damage; instead, the
fairly straightforward risk of insolvency of the underlying obligor had materialized.


Capital Markets Law Journal, 2011, Vol. 6, No. 4

given to the Eurosystem as collateral for the refinancing business of Lehman in the
Open-market business of NCBs

11 On the full range of tasks of the ESCB see Joseph de Wolf and Dominique Servais, Tasks of the Eurosystem and of the
National Central Banks (2009) 3 Euredia 441, 447. On its legal nature Etienne de Lhoneux, Decentralisation and Specialisation in
the Eurosystem (2009) 3 Euredia 455, 457, 467.
12 On the principals of the European System of Central Banks see Krauskopf and Steven, The Institutional Framework of the
European System of Central Banks: Legal Issues in the Practice of the First Ten Years of its Existence (2009) 46 CMLR 1143.
13 On the full range of the competences shared by the ECB and the NCBs see Jean-Victor Louis, LAutorite monetaire de la zone
Euro (2009) 2 Euredia 277.
14 This is reflected in the terms and conditions of the Bundesbank, see ch V, no 1 para 1, no 2 para 1, no 3, no 13 and no 23 para
1. Available at 5http://www.bundesbank.de/download/presse/publikationen/agb.pdf4 (available in German only), accessed 30
August 2011.
15 Guideline of the European Central Bank of 31 August 2006 amending Guideline ECB/2000/7 on monetary policy instruments
and procedures of the Eurosystem (ECB/2006/12), OJ 2006 L 352/4, annex, ch 4.1.

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Liquidity in the euro-area is provided to credit institutions by the Eurosystem as part of

its task to conduct the monetary policy of the union.11 The Eurosystem consists of the
European Central Bank (ECB) and the National Central Banks (NCBs) of the Member
States whose currency is the euro as provided in Article 282, sections 1 and 2 of the Treaty
on the Functioning of the European Union (TFEU).12 Whereas the ECB determines,
above all, the basic political issues of monetary policy, the NCBs implement this policy by
inter alia providing liquidity to credit institutions.13 This is mainly done via so-called
open-market operations which can be entered into using two legal techniques: One is by
way of a repurchase agreement in which the ownership of an asset is transferred to the
NCB on the purchase day which coincides with the day as of which central bank money
shall be provided. The parties agree to reverse the transaction through a re-transfer of the
asset to the counterparty on the repurchase day, which coincides with the end of the
usually short-termed operation. This is the so-called repo-business.
The other technique is a collateralized loan to the institution, which requires an
enforceable security interest over assets provided by the institution. The NCBs enter into
a contractual agreement with the institution (called the counterparty).14 The NCB
becomes the creditor of the institution and the holder of the security rights in full title to
assets offered as collateral. The security rights remain with the NCB at least until maturity
of the operation, but usually much longer as they may be used for future operations (eg
in the case of pooled collateral). As a result, the claims and obligations show in the
balance sheets of the NCB (not of the ECB). The NCB executes the transaction and
realizes the collateral if necessary. The counterparty has the right to withdraw a collateral
asset if the remaining NCB exposure is sufficiently covered by the remaining assets.15
The open-market business is part of the tasks defined by Article 127 TFEU. Above all,
the Eurosystem has to define and implement the monetary policy of the Union. As a
consequence, the NCBs must pursue the monetary policy of the Eurosystem when
engaging in the open-market business. Hence, the mere pursuit of profit is no legitimate
purpose under the NCBs role in the Eurosystem as outlined by the TFEU and Article 18
of the Protocol on the Statute of the European System of Central Banks and of the

Christian Hofmann  Central bank collateral and the Lehman collapse


European Central Bank (hence-forth the Statute).16 At the same time, the NCBs are not
limited to the duties given to them in their capacity as members of the Eurosystem. NCBs
have a double nature: they are part of the Eurosystem, and they are the central banks of
their Member States.17 Accordingly, national law can provide further tasks: According to
Article 14.4 of the Statute, NCBs may perform functions other than those specified in
this Statute unless the Governing Council finds, by a majority of two thirds of the votes
cast, that these interfere with the objectives and tasks of the ESCB.18
Eligible counterparties

16 Protocol annexed to the Treaty establishing the European Community (OJ 1992 C 191/68), as amended by the Treaty of
Amsterdam (OJ 1997 C 340/1), the Treaty of Nice (OJ 2001 C 80/1), Council Decision 2003/223/EC (OJ 2003 L 83/66) and the Act
concerning the conditions of Accession of the Czech Republic, the Republic of Estonia, the Republic of Cyprus, the Republic of
Latvia, the Republic of Lithuania, the Republic of Hungary, the Republic of Malta, the Republic of Poland, the Republic of Slovenia
and the Slovak Republic and the adjustments to the Treaties on which the European Union is founded (OJ 2003 L 236/33).
17 Joseph de Wolf and Dominique Servais (n 11) 441, 452; Etienne de Lhoneux (n 11) 455, 457 and 483.
18 When a national legislator intends to entrust a national central bank with a new task, it is required to consult the ECB
beforehand as part of the general obligation to consult the ECB with all legislative acts which affect the NCBs, art 127 para 4, 282
para 5 TFEU in connection with Council Decision 98/415/EC, OJ 1998 L 189/42. On this see also Joseph de Wolf and Dominique
Servais (n 11) 441, 452 et seq.
19 On the requirements see Guideline of the European Central Bank of 31 August 2006 amending Guideline ECB/2000/7 on
monetary policy instruments and procedures of the Eurosystem (ECB/2006/12), OJ 2006 L 352/12, annex 1, ch 2.1.
20 The European Economic Area (EEA) was established by The Agreement creating the European Economic Area, OJ 1994 L 1/
3, which entered into force on 1 January 1994. It allows Norway, Iceland and Liechtenstein (which are part of the European Free
Trade Association (EFTA)) to participate in the Internal Market on the basis of their application of Internal Market relevant acquis.
21 This can be deducted from the Additional Minimum Common Features in annex 1 of ECB 2000/7 as amended by ECB 2008/
13 which all require a default by the institution and a decision by the NCB.
22 On this see the judgment of the German Federal Supreme Court (Bundesgerichtshof) of 29 May 1978 (II ZR 89/76), Neue
Juristische Wochenschrift 1978, 1852.

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Article 18 of the Statute provides that the ECB and the NCBs may conduct credit
operations with credit institutions with lending being based on adequate collateral.
Adequate collateral is therefore conditional for any transfer of liquidity to a credit
Only institutions which fulfil the requirements set out in the contractual rules of the
NCBs (implementing and in line with annex 1, Chapter 2.1 of Guideline ECB 2006/12)
are eligible counterparties for the open-market business of the Eurosystem.19 The
institutions must be subject to the Eurosystems minimum reserve requirements and
must be financially sound, which is presumed as long as they are subject to harmonized
EU or European Economic Area (EEA) supervision.20 The head office of an institution
can be outside of the EU/EEA as long as its branches established and supervised in the
EU/EEA act on its behalf.
There are no guidelines by the Eurosystem on how to evaluate the soundness of an
institution. The NCBs, therefore, do not engage in a separate soundness check of the
institutions but rely on the supervision carried out by the supervisory authorities of the
EU/EEA Member States.21 An additional check by the Eurosystem would lead to a double
evaluation of an institutions soundness, by the authorities on the one hand and the
Eurosystem on the other hand, and potentially result in contradictory results.22 If the


Capital Markets Law Journal, 2011, Vol. 6, No. 4

NCBs excluded institutions from participation in the open-market business or

terminated operations on their own accord, they might provoke market-reactions,
which could interfere with efforts by the authorities, which may be arranging measures to
re-establish the soundness of institutions.23 The protection of the Eurosystem against
credit risk, therefore, focuses on the status of the counterparty as a supervised credit
institution and in addition on the requirement of adequate collateral. This emphasizes
the importance of a rigid regime for collateral.
The requirement of adequate collateral

Uniformity of criteria

The Eurosystem has developed a single framework for eligible assets common to all
Eurosystem credit operations. The eligibility criteria are therefore uniform across the
euro area.24 The requirements for adequate collateral are set out in the Guideline ECB/
2000/7 on monetary policy instruments and procedures of the Eurosystem.25 This
guideline undergoes increasingly frequent amendments, most recently by Guideline ECB/
2010/13, which came into effect on 10 October 2010.26 The ECB booklet on The
Implementation of Monetary Policy in the Euro Area (called the general documentation) is a consolidated (yet unofficial) version that includes all amendments and
therefore represents an up-to-date version of the seven chapters of the annex to Guideline
ECB/2000/7. The latest version of this booklet is of February 2011.27
Assessment of adequacy

To ensure compliance in the euro area, a credit assessment framework (Eurosystem credit
assessment frameworkECAF) was set up which relies on different credit assessment
23 On all of the above, see Christoph Keller, in: Siekmann (Hrsg.), Kommentar zur europaischen Wahrungsunion, Art 18
24 This new legal framework entered into effect on 1 January 2007 and replaced the former two level system, see ECB, The
Implementation of Monetary Policy in the Euro Area, February 2011, 45.
25 OJ 2000 L 310/1.
26 Guideline of the European Central Bank of 16 September 2010 amending Guideline ECB/2000/7 on Monetary Policy
Instruments and Procedures of the Eurosystem (ECB/2010/13), OJ 2010 L 267/21.
27 Available at5http://www.ecb.int/pub/pdf/other/gendoc2011en.pdf?0ba74eeb0d90a203aa5e5b427c87e1074accessed 30 August

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Article 18.1 (second indent) of the Statute requires adequate collateral for these lending
operations. The purpose of the collateral is to secure the claims resulting from the
open-market business and to protect the balance sheets of the NCBs. Moreover, it
simplifies the open-market business as well as the access to liquidity for institutions.
Adequate collateral should cover the entire exposure and ideally make the complex
process of evaluating the soundness of the institutions redundant (notwithstanding the
supervision by the authorities). By doing so, it allows equal access to monetary policy
(Overnight) repurchase agreements are collateralized per se because they require a
transfer of the ownership of the asset, which underlies the re-purchase agreement. For
loans, collateral needs to be granted separately.

Christian Hofmann  Central bank collateral and the Lehman collapse


sources. The procedures and rules establishing and controlling the Eurosystems
requirement of high credit standards for all eligible collateral are regulated in chapters
6.3 and 6.4 of the general documentation.

Rating types and rating results: The difference between marketable and non-marketable
assets is also relevant for the rating requirements. If available, an external rating by an
external credit assessment institution (ECAI) is mandatory. This is the case for most
marketable assets. For all other assets, the ECAF provides further rating approaches. The
rating can also be done by the counterparty itself and is therefore internally based (called
IRBInternal Rating Based). If the NCB does the rating, it conducts an in-house credit
assessment system (ICAS). Currently, there are four NCBs entitled to perform in-house
assessments: the Austrian, French, German and Spanish Central Bank (O
Nationalbank, Banque de France, Deutsche Bundesbank, Banco de Espana). Finally,
rating tools (RTs) by third parties can be applied. Given that the Eurosystem assesses the
assets in only a limited number of cases itself (the ICAS cases) it chooses to rely heavily
on external ratings.
Marketable assets must receive at least one credit assessment from an accepted ECAI.
The minimum rating requirement is BBB-. In case of several available ratings, the first
best rule applies and only the best rating is taken into account. If no or no acceptable
ECAI credit assessment of the issuer is available, high credit standards can be established
on the basis of guarantees provided by financially sound guarantors.29
Haircuts: As a further security measure, the Eurosystem considers the prospects of
realizing the assets in the markets and accordingly applies haircuts. The assets are
28 Christoph Keller (n 23); on the potential legal risks of collateral Federico de Tomasi, Legal Aspects of the European System of
Central Banks: liber amicorum Zamboni Garavelli, 2005, 355, 358 et seq.
29 ECB (n 24) 61.

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Easy to transfer and realize: Whereas commercial banks generally accept assets like real
estate, vehicles, ships, warehouses and assignment of claims, the Eurosystem requires that
the title of the asset is easy to transfer and the value of the asset easy to realize in order to
limit the exposure to risk. This narrows down the eligibility of assets significantly.28
Chapter 6 of the annex to Guideline ECB/2000/7 sets out three groups of eligibility
requirements to be fulfilled by an asset to become eligible: administrative (non-soundness
related) requirements, rating (soundness related) requirements and procedural requirements. The administrative requirements limit the group of potential debtors in terms of
territorial location, supervisory status, etc, requires that debt instruments be
denominated in euros and requires that theyin the case of securitiesbe issued in
the EEA and their delivery/pledging to be subject to the law of a euro area Member State.
The requirements for non-tradable securities are generally higher and therefore more
restrictive than those for tradable securities. The procedural side requires that all
admissible assets be recorded in the eligible assets database (EAD) with the exception of
credit claims and bonds without external rating.


Capital Markets Law Journal, 2011, Vol. 6, No. 4

grouped into five liquidity categories, based on issuer classification and asset type. Group
one supposedly offers the highest, group five the lowest imminent liquidity, ie the assets
in group one have the shortest, the assets in group five the longest foreseeable delay for
realization. Long residual maturities of debt instruments attract higher haircuts than
shorter ones. Central government debt instruments are ranked in group one, ABS in
group five.30 In group five the haircut is generally 16 per cent.31

Recent developments

The eligibility requirements were generally eased after the Lehman collapse and the
triggering of the financial crisis. It was a measure by the Eurosystem that was aimed to
secure liquidity of the markets. The minimum rating for central government debt
instruments was reduced to BBB- and at the same time the haircut raised by 5 per cent,
first on a merely temporary basis.33 On 1 January 2011, these changes became the general
rule.34 What is more, the Governing Council of the ECB has granted further exceptions
from these rules since May 2010. By decisions of 6 May 2010, 31 March 2011 and 7 July
2011 the general requirements have been adjourned for Greek, Portuguese and Irish
sovereign bonds which now are eligible regardless of their actual rating.35 In the
aftermath of the decisions by the council of the European Union of 21 July 2011, the
Eurosystem will have to decide if at all and under which conditions sovereign bonds with
a rating of selective default (SD) will still be accepted.36
30 See for a full classification ECB (n 24) 72, table 6.
31 Compare ECB (n 24) 73, table 7.
32 ECB (n 24) 53.
33 By Guideline ECB/2008/18 and (extension) by guideline ECB/2009/24.
34 By amending guideline ECB/2000/7 by guideline ECB/2010/13, annex 2.
35 Decision of the European Central Bank of 6 May 2010 on temporary measures relating to the eligibility of marketable debt
instruments issued or guaranteed by the Greek Government (ECB/2010/3), OJ 2010 L 117/102; Decision of the European Central
Bank of 31 March 2011 on temporary measures relating to the eligibility of marketable debt instruments issued or guaranteed by
the Irish Government (ECB/2011/4), OJ 2011 L 94/33; Decision of the European Central Bank of 7 July 2011 on temporary
measures relating to the eligibility of marketable debt instruments issued or guaranteed by the Portuguese Government (ECB/2011/
10), OJ 2011 L 182/31.
36 See the statement at 5http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/123978.pdf4 accessed 30
August 2011.

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Close link to the counterparty: To separate the collateral from the liability of the
counterparty, the Eurosystem does not accept any assets that were issued or guaranteed
by the counterparty or by any entity closely linked to the counterparty. This includes
instances in which the counterparty owns directly, or indirectly, through one or more
other undertakings, 20% or more of the capital of the issuer/debtor/guarantor; or the
issuer/debtor/guarantor owns directly, or indirectly through one or more other
undertakings, 20% or more of the capital of the counterparty; or a third party owns
more than 20% of the capital of the counterparty and more than 20% of the capital of the
issuer/debtor/guarantor, either directly or indirectly, through one or more undertakings.32 In such cases, the assets may qualify as collateral, but they cannot be used by
the counterparty, which fulfils the close link conditions.

Christian Hofmann  Central bank collateral and the Lehman collapse


The collateral requirements for ABS

High-risk collateral

Special requirements apply to ABS. ABS are issued by special purpose entities or vehicles
which ideally own the underlying claims.37 ABS do not have a fixed, unconditional
principal amount and are therefore exempted from this Eurosystem eligibility requirement that applies to all other debt instruments.38 The underlying assets are various
receivables that are pooled and securitized. ABS have always been considered the least
liquid of the assets eligible for collateral, and the financial crisis revealed their actual
potential for hazards. As a consequence, the collateral requirements for ABS were
amended several times, most recently in December 2010.39
Rating requirements

Incorporation or residence in EEA

A further recent change in the rules on the eligibility of ABS concerns the applicable law
and the residence of the parties involved. The underlying assets of ABS are receivables.
One of the reasons for the difficulties in the realization of the underlying assets in the
recent past was the fact that the debtors of the receivables could reside or be incorporated
anywhere in the world and in some cases were American debtors. Until 2010, the
37 On special purpose entities see Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating
to the taking up and pursuit of the business of credit institutions (recast), OJ 2006 L 177/1, art 4, para 44.
38 Usually, Asset Backed Securities are created in several steps: Loans are bundled and transferred to a special purpose entity that
passively holds the loans. The entity creates and issues the asset backed securities and the securities to investors. On this see
Kathleen C. Engel and Patricia A. McCoy, A Tale of Three Markets: The Law and Economics of Predatory Lending (2002) 80
TXLR 1255, 1274.
39 Guideline of the ECB of 13 December 2010 amending Guideline ECB/2000/7 on monetary policy instruments and procedures
of the Eurosystem (ECB/2010/30), OJ 2010 L 336/63.
40 ECB (n 24) 59 et seq.

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The rating requirements for ABS are now fairly high compared to other assets. An
external rating is required, and the ECAI must explain the rating result in a detailed and
publicly available credit rating report. Among other elements, the report must explain the
structural and legal aspects, the composition of the collateral pool, must name
the transaction participants and analyse the particularities of the transactions. Besides, the
ECAI must publish regular surveillance reports, which should at least contain an update
on the key transaction data and describe the performance. These publications should be
in line with the frequency and timing of coupon payments.
At least two credit assessments by accepted ECAIs are necessary. They must both result
in a rating of AAA at issuance and never drop below a rating of A for the entire lifetime
of the ABS.40 If more than two assessments exist, the second best rule applies: at least
two AAA-ratings are necessary.
Once more, the reliance of the Eurosystem on external ratings becomes obvious. The
Eurosystem focuses on formal criteria when it assesses the eligibility of ABS, not on the
intrinsic value of the underlying claims. It relies on the judgment of the rating agencies
that usually put a greater focus on the liability side (size of lower tranches).


Capital Markets Law Journal, 2011, Vol. 6, No. 4

collateral rules did not hinder this practice since only the issuer and guarantor of the ABS
had to be based in the EEA. It was a common practice to incorporate the special purpose
entities in the Republic of Ireland, whereas in many cases the debtors to the underlying
receivables were located outside of the EEA. The current rules for ABS with underlying
credit claims require that the obligors and the creditors must be incorporated (or, if
natural persons, residents) in the EEA and, if relevant, the related security must be located
in the EEA.41

The principle of shared collateral

As explained above (in the section entitled Open-market business of NCBs), the NCBs
are the sole contractual partners of the institutions and accept each eligible collateral as
long as it is listed in the EADregardless of its geographical or legal location. As a
consequence, collateral can be used throughout the euro area vis-a`-vis any NCB.43 The
initial assessment is carried out by the NCB where an asset is admitted to trading on a
regulated market or traded on a non-regulated market.44
This procedure eases the effect of another collateral requirement according to which an
institution can only approach the NCB in the country in which it maintains an
establishment. Each establishment therefore has access to the Eurosystem operations
through the NCB of the Member State in which it is located.45 As a result, it is possible
that a local branch uses assets generated by the headquarters in another country for its
transactions with the NCB of its country of registry.
The Eurosystem also facilitates the cross-border use of collateral by way of the
Corresponding Central Banking Model (CCBM).46 One NCB becomes the
Correspondent Central Bank (CCB) of another NCB. The CCB provides information
to the other NCB on the delivery and eligibility of the assets. The second NCB processes
this information and, based on the result, provides liquidity to the counterparty.47
41 ECB (n 25) 47.
42 ECB (n 25) 47.
43 Compare ECB (n 25) 45. On the general principal of decentralization in the ESCB and its exceptions see also Etienne de
Lhoneux (n 11) 455.
44 See for the details on the eligibility assessment procedure at 5www.ecb.int/paym/coll/standards/marketable/html/index.en.
html4 accessed 30 August 2011. Also compare Federico de Tomasi liber amicorum Zamboni Garavelli (n 28) 355, 363.
45 Guideline of the European Central Bank of 31 August 2006 amending Guideline ECB/2000/7 on monetary policy instruments
and procedures of the Eurosystem (ECB/2006/12), OJ 2006 L 352/12, annex, chapter 2.1.
46 See the ECB guidelines in the Correspondent Central Banking Model of 1/2011 at 5http://www.ecb.int/pub/pdf/other/
ccbm201101en.pdf4 accessed 30 August 2011.
47 On this process see the ECB guidelines in the Correspondent Central Banking Model of 1/2011, p 6 et seq.

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Another major issue with ABS is their multi-layered structure that can involve different
layers of debtorcreditor relations. In the past, it was common to create ABS of ABS or
repackage other complex financing transactions into ABS as often found in Collateralized
Debt Obligations (CDOs) or Collateralized Loan Obligations (CLOs). Here as well, the
rules on Eurosystem collateral were changed in 2010. Now, ABS must not consist, in
whole or in part, actually or potentially, of tranches of other asset backed securities.42

Christian Hofmann  Central bank collateral and the Lehman collapse


For marketable assets, the CCB is generally the NCB of the country of the issuing security
settlement system (SSS).
Another form of cooperation concerns the need for constant evaluation of assets
during the entire period in which they serve as collateral. For some assets, the markets
provide regular prices. For other assets, there is no permanent assessment by the markets.
For this latter group, the Eurosystem has established so-called Valuations Hubs. One
NCB becomes the Valuation Hub for the Eurosystem and evaluates certain groups of
collateral on a daily basis. The results can be accessed by the entire Eurosystem.
The principle of loss sharing

4. The Lehman scenario

Open market business in the euro area
The Lehman insolvency had implications on the Eurosystem open market and collateral
system and led to the before-mentioned changes. Lehman Brothers Bankhaus AG was
admitted to the Eurosystem open-market business since it was the only one of many
subsidiaries of Lehman in the euro area holding a licence as a fully fledged credit
institution thus allowing the Lehman Group to cover its entire demand for euros through
this channel. In accordance with the above-described principles that allow credit
institutions to approach the Eurosystem thanks to their regulatory status and (ideally) the
quality of their collateral (Section 3, Eligible counterparties), Lehman Brothers
Bankhaus AG engaged heavily in the open-market business with the Bundesbank. It
passed the borrowed euros on to other Lehman establishments, above all to the Lehman
branch in London. As a result, the Deutsche Bundesbank became a major creditor of
Lehman Brothers Bankhaus AG.
Lehman provided two types of collateral. One group consisted of top-rated sovereign
bonds that are considered prime collateral.49 However, they made up only a very small
48 See Deutsche Bundesbank, Annual Report 2010, 173.
49 See ECB (n 24) 73, table 7.

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According to a decision by the ECB Governing Council based on Article 32.4 section 2 of
the Statute, the NCBs generally participate in a loss sharing if the collateral falls short.48
Hence, if the Bundesbank should ultimately be unable to satisfy its claims against Lehman
Brothers Bankhaus AG by realization of the collateral, it will not bear the losses alone, but
only with its stake in the Eurosystem that amounts to about 27 per cent. To avoid any
misunderstanding: The gains and losses from liquidity transactions are shared among the
central banks in the Eurosystem. There is, however, no liquidity contingent, which would
limit the amount of tender granted by the central banks. If most of the liquidity
transactions happen to take place in Germany, the Bundesbank is not limited to a certain
amount. As long as the collateral requirements are met, it is free to fulfil every demand
for liquidity in its tender procedures by every institution which maintains an
establishment in Germany.


Capital Markets Law Journal, 2011, Vol. 6, No. 4

portion of the collateral. The second group consisted of ABS, which have proven to be far
more difficult to realize. The second group makes up the vast amount of collateral given
to the Deutsche Bundesbank (99 per cent).
Several NCBs were involved in the process. The Bundesbank provided the euros. The
ABS, however, had first been issued by an Irish Lehman subsidiary in Ireland. The Bank
of Ireland enlisted the ABS in the EAD. When they were given as collateral, the ABS were
held for Lehman by a services provider in Belgium. The Belgian National Bank became
the CCB for the Bundesbank (on the procedure see the section entitled The principle of
shared collateral). The value of the ABS was determined on an ongoing basis by the
Banque de France which was (and still is) the Valuation Hub for ABS.
Moratorium and insolvency proceedings

50 Sec 19 para 1 sentence 3 regulates: (. . .) when the debt falls due, the Bank is entitled to sell pledged assets by auction through
one of its employees or through a person authorised to sell by auction or, if the pledged asset has a stock market or market price, to
sell it at the current price through one of the aforementioned persons or through a broker and to indemnify itself for expenses,
interest and principal out of the proceeds or to acquire the pledged asset, in which case the claims of the Bank in the amount of the
stock market or market price lapse; the Bank also has these rights relative to other creditors, relative to the estate of an insolvent
debtor and in the event of a previous protective measure taken in respect of the debtor; this also applies if the Bank is acting on
behalf of another member of the European System of Central Banks.
51 See Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements,
OJ 2002 L 168/43, amended by Directive 2009/44/EC of the European Parliament and of the Council of 6 May 2009 amending
Directive 98/26/EC on settlement finality in payment and securities settlement systems and Directive 2002/47/EC on financial
collateral arrangements as regards linked systems and credit claims, OJ 2009 L 146/37, art 4 and 8. On the directive in detail
Federico de Tomasi liber amicorum Zamboni Garavelli (n 28) 355, 369374.

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On 15 September 2008, the German banking authority (Bundesanstalt fur Finanzdienstleistungsaufsicht, (BaFin)) issued a moratorium against Lehman Brothers Bankhaus AG
according to section 46a of the German Banking Act (Gesetz uber das Kreditwesen,
(KWG)). The banking authority believed that Lehman Brothers Bankhaus AG might not
be able to fulfil its obligations towards its creditors and by that threaten market stability.
Shortly afterwards, Lehman Brothers Bankhaus AG filed for insolvency proceedings,
which were formally opened on 13 November 2008.
With the moratorium it became obvious that the claims of the Bundesbank against
Lehman Brothers Bankhaus AG were unsustainable. The collateral granted to the
Bundesbank in exchange for liquidity was unaffected by the moratorium as well as the
insolvency proceedings. The insolvency administrator is not permitted to realize assets
that have been given as collateral to the ECB or an NCB of the EEA according to section
166 (3) No 2 of the German insolvency code (Insolvenzordnung, (InsO)). Section 19
Bundesbank Act entitles the Deutsche Bundesbank to realize the assets irrespective of
other creditors or the insolvency proceedings.50 These national provisions are in
accordance with the European requirements for central bank collateral. The Member
States are required to ensure that the collateral arrangements stay unaffected by any
insolvency proceedings affecting the counterparty, be it in the form of a winding-up or a

Christian Hofmann  Central bank collateral and the Lehman collapse



5. Concluding remarks
The Lehman crisis has changed the financial world. It comes as no surprise that it has had
its impact on the Eurosystem as well. The Bundesbank as one of the Eurosystems NCBs
holds claims against one of its subsidiaries from its refinancing operations. As a result, it
became obvious that the former rules on the acceptance of ABS as collateral were too
generous. It turned out that ABS of various kinds could not easily be realized. The
multi-layered ABS implied risks with respect to strict standards for Eurosystem collateral.
These findings have led the Eurosystem to make changes to the existing rules.
Multi-layered ABS are no longer accepted as collateral. What is more, the debtors of
underlying credit claims must be located in the EEA. In addition to that, given the
complexity of ABS ratings, the applied haircuts have been elevated.
The system itself has not undergone any changeand rightly so since there was and is
no need for such an amendment. The losses to the Eurosystem resulting from the Lehman
collapse are no outcome of the principle of shared collateral but of requirements for ABS,
which turned out to be too weak. There is no feasible alternative to the existing model
that entrusts only one NCB with the decision about enlisting assets into the EAD and
therefore their eligibility for the whole Eurosystem. To involve several NCBs in the
situation of cross-border collateral would complicate and slow down the process with
detrimental effect to the counterparties. The arguments in favour of the principle of
shared collateral are similar to those in favour of relying on the single soundness check of
the counterparties carried out by the banking supervisors.53 What is more, the principle
of loss sharing burdens each NCB with a substantial interest in a proper evaluation of the
adequacy of every asset. This should ensure the quality of the evaluation.

52 LB Re Financing No 3 Ltd against Excalibur Funding No 1 PLC, Deutsche Bundesbank and US Bank Trustees Limited, (2011)
EWHC 2111 (Ch).
53 On these arguments see Section 3, Eligible counterparties.

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Recently, a court decided on an aspect deriving from the Lehman assets given as
collateral. Justice Briggs in the High Court of Justice (chancery division) decided on 29
July 2011 about the claims of LB Re Financing No 3 Ltd, against Excalibur Funding No 1
PLC, Deutsche Bundesbank and US Bank Trustees Limited.52 The claimant is the holder
of class B notes of ABS, the Bundesbank of class A notes. The position of the Bundesbank
results from the collateral given by Lehman Brothers Bankhaus AG. The parties disagree
about an event of default that may have disabled the rights of the class B noteholders. The
judgment is of no relevance to the principles of collateral of the Eurosystem, but it
illustrates a potential outcome of the system. When the counterparty fails to pay its debt,
the NCB exercises the rights of the collateral. If the collateral cannot be sold
(immediately) the NCB is forced to manage the assets which may result in legal disputes
with third parties.