This piece has been adapted from a new academic article by Levitin, “Bankruptcy's Lorelei: the Dangerous Allure of Financial Institution Bankruptcy.”
The idea of resolving failed financial institutions in bankruptcy rather than through an administrative process like the Dodd-Frank Act’s “orderly liquidation authority” is a dangerous siren song in the financial regulatory world.
The Lorelei of financial institutions, bankruptcy promises a transparent, predictable process that eliminates moral hazard by imposing losses on credits and shareholders. Financial institutions bankruptcy holds out the rule of law, rather than ad hoc bailouts and cronyism.
Indeed, because of this, the Treasury Department recently fell for the idea of creating a new Chapter 14 bankruptcy process for financial institutions to complement the existing OLA for resolving large failed financial firms. Treasury claims that the presence of a Chapter 14 bankruptcy for financial institutions would make the likelihood of having to use Dodd-Frank’s authority more remote.
The Chapter 14 proposal promises a world of market discipline that will prevent financial crises. In fact, it is a cover for a deregulatory agenda that will make crises more likely by undermining prudential regulation without replacing it with market discipline. And because Chapter 14 is unworkable as a practical matter, it will be a recipe for bailouts.
The bankruptcy process will supposedly engender greater market discipline because it will force losses on creditors of failed financial institutions. If creditors will know that they will have to internalize the losses, they will lend prudently, making prudential regulations on banks unnecessary.
Such market discipline would exist, however, only if Chapter 14 were a credible process, such that creditors truly believe that it will be used and that they will incur losses in a financial institutions bankruptcy. But it should be apparent to even the most casual observer that it is utterly lacking in credibility and, if enacted, would never be used.
Chapter 14 lacks credibility for three reasons. First, large financial firms operate internationally — yet Chapter 14 does nothing to ensure coordination and cooperation from foreign regulators, who are likely to ring-fence assets in their jurisdictions at the first signs of trouble.
It is hard to imagine foreign regulators quickly coming to a cooperation in an unfamiliar U.S. court in the midst of a financial crisis. Contrast this with the strong informal relationships that U.S. financial regulators have with their foreign counterparts that facilitated trust and coordination in the 2008 financial crisis. What this means is that Chapter 14 is a non-starter for any financial institution that has a significant international presence.
A second problem with Chapter 14 is that it lacks a viable mechanism for financing the bankruptcy. Financial institutions need enormous liquidity to keep operating in bankruptcy and to maintain counterparty confidence — for JPMorgan, for example, that would be around $500 billion in high quality, liquid assets.
Where can one find financing to cover even a fraction of that on virtually no notice and in distressed financial markets? The largest private bankruptcy financing in history was a mere $9 billion, and that was in non-distressed markets. Moreover, any such financing would need to be arranged in advance, but merely shopping for such financing is likely to precipitate a run on the firm, resulting in a disastrous bankruptcy before financing can be lined up. The idea that private markets can supply the level of financing needed for one such bankruptcy of a major bank — let alone many simultaneous ones — is preposterous.
While private markets are unable to provide adequate financing for a Chapter 14, the federal government could, in theory provide such financing. The whole point of Chapter 14, however, is to keep the government out of the bailout business. Once the government is involved, it will assuredly flex its muscles and use its control over the financing to get favorable treatment in the bankruptcy for favored constituencies. Recall the much-maligned Chrysler and General Motors bankruptcies, where the U.S. government used its position as financier to push through an asset sale that benefited certain creditors favored by the government.
Treasury downplays the liquidity concern by noting that the liquidity coverage ratio and resolution plans should ensure adequate liquidity. But this is no answer — a financial firm that is filing for bankruptcy will surely be flunking its liquidity coverage ratio and is unlikely to have the assets assumed by its resolution plan. Treasury also argues that financing is only needed for 48 hours — the duration of the stay on derivatives contracts — during which time the failed institutions’ assets will all be transferred to a solvent buyer. This is naively optimistic: There is no guarantee that a buyer can be found in distressed markets in 48 hours. And the idea of a massive asset sale within 48 hours makes a mockery of the judicial process in which Chapter 14 is clothed. What sort of due process can there be in such circumstances? How is this instilling the rule of law?
Where the credibility of Chapter 14 truly fails, however, is in its insistence that regulators will permit market discipline to take its course when the effects are disruptive.
Failed financial institutions present a policy dilemma: Do we want creditors to take losses or do we want to minimize economic disruption? We can’t do both. Imposing losses increases economic disruption, and “foaming the runway” undermines market discipline. Chapter 14 asks us to believe that concerns about market discipline will trump concerns about minimizing economic disruption.
Market discipline is great, but everyone knows it’s not a suicide pact. When faced with the choice, regulators will always foam the runway and deal with the political and legal fallout later — and that’s the result Congress wants, even if it’s impolitic to say so.
Chapter 14, then, is not going to deliver on its promise of market discipline because it isn’t credible that the procedure will ever be used — and if it is, it will be with government intervention that makes the process nothing more than a bailout in bankruptcy clothing. At the same time, however, Chapter 14 will be used to undermine prudential regulation as redundant given the market discipline Chapter 14 supposedly creates. In the end, we will have neither market discipline nor prudential regulation.
This is why Chapter 14 is such a pernicious proposal: It will make financial crises — and bailouts — more likely rather than less, all in the name of an ideologically motivated policy position with glaring practical deficiencies.