The Bankruptcy Exemption

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The 2013 Banking Resolution Conference, organized by the Federal Reserve Bank of Richmond and the Board of Governors of the Federal Reserve System, was a gripping affair. Ordinarily such technical meetings are dry, with a large number of lawyers and regulators using a great deal of jargon and arguing out minutiae. But this day began with a fascinating discussion centered on an enormous revelation.

The big and important news is that bankruptcy cannot work for large, complex financial institutions in the United States, at least not using the current bankruptcy code. On this there was complete unanimity among the country’s top financial-sector lawyers, some of whom work for big banks.

More specifically, if any such companies were to go bankrupt - as Lehman Brothers did in September 2008 - then global financial panic and potential chaos would follow, on the scale of fall 2008 or greater. There were three reactions to this stark agreement on the facts.

First, Paul Saltzman, president of the Clearing House Association, a trade organization of banks, suggested that we should not think too much about bankruptcy for big banks (which falls under Title I of the Dodd-Frank financial reform legislation of 2010; see, for example, Section 165), because we have â€" in Title II of Dodd-Frank â€" an alternative “resolution mechanism.” (The full text of the act is available from the Securities and Exchange Commission.)

Under this arrangement, the Federal Deposit Insurance Corporation, with agreement from the Federal Reserve and the Treasury, can act as a type of official liquidator for a big bank, which involves imposing losses on shareholders and bond holders while also providing short-term lending to parts of the business that are considered viable (e.g., derivatives trading operations, which are often cited in this context).

But the problem with Mr. Saltzman’s approach is that the law clearly states big banks should be able to go bankrupt. The Title II resolution mechanism is only there in case, despite their best efforts, the regulators are surprised to find that bankruptcy won’t work in a particular situation. Title II is a backup - i.e., a form of fail-safe; it is not intended to replace bankruptcy. (I’m a member of the F.D.I.C.’s Systemic Resolution Advisory Council, but the views here are mine alone.)

Second, Emily Warren of the Hoover Institution asserted that we needed to reform our bankruptcy laws; she was reporting in part on a broader and longstanding Hoover project along these lines. That may be true, but I could not find anyone who thought that such reform was even a remote possibility in the near future. There were also important questions raised about whether a bankruptcy court judge could quickly administer such a complex process while adhering to all appropriate due process.

Experience in the case of Lehman has not been encouraging, particularly with regard to how courts coordinate across different legal systems (in general, they don’t). One reason for the global panic was that regulators and other officials seized or froze assets in their jurisdiction, hoping to reduce the cost of the collapse there. But the overall effect was to increase the uncertainty over the worth of various kinds of financial claims.

Another prominent issue is that many banking experts - and some regulators - feel that large banks would need “liquidity loans” if any of their operations were to remain a going concern at a time of trouble. It is hard to see a bankruptcy judge administering such loans, running into the billions or tens of billions of dollars (think about the scale of support provided to A.I.G.). What would be the economic impact of and political backlash against those decisions?

If anyone is to administer large amounts of financing, our eyes will once more turn to the Federal Reserve System.

Third, the Board of Governors of the Federal Reserve has a much bigger problem with big banks than it has acknowledged. There is a process, mandated under Dodd-Frank (Title I, Section 165), through which very large financial institutions prepare what are now known as “living wills.” In this context, the term is a misnomer, because these documents are supposed to explain how it would be possible for these companies to fail - i.e., go bankrupt - without any kind of official intervention or help.

It is hard to find anyone - official or in the private sector - who thinks that living wills currently provide a road map explaining how bankruptcy could become a real possibility for large complex financial institutions.

Nonfinancial companies fail - i.e., go bankrupt - with great regularity. Small banks can and do fail; the F.D.I.C. is involved when there are insured deposits, but there are no liquidity loans or thoughts of keeping on management. Medium-sized financial institutions can also be forced to reorganize their debts; this happened to CIT Group in fall 2009 (its total assets were around $80 billion).

It completely distorts the marketplace to have a small number of very large companies that are exempt from bankruptcy - and that can line up for special treatment. Everyone in the corporate sector would like to have access to some form of back-up government-provided “liquidity facility.” But this is not allowed for good reason; it would have a distortive effect on incentives.

Because big banks cannot go bankrupt, they have an unfair advantage against everyone else in the financial sector. The counterparty risk of trading with them is lower, and thus they are regarded as a better credit risk than would otherwise be the case. This allows them to place bigger bets, which in turn creates more risk for the macroeconomy.

The intent behind Title I of Dodd-Frank is clear. If large complex financial institutions cannot go bankrupt, then they must be forced to change the scale and nature of their operations until each and every company is small enough and simple enough to fail without disrupting the world economy.