Big Banks and the Failure of Bankruptcy

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.”

In modern American political discourse, it is unusual to see ideas explode before your very eyes. It’s much more typical for bad ideas to drift away quietly - or alternatively to stick around, year after year, despite being completely at odds with the facts.

On Dec. 11, at a meeting at the Federal Deposit Insurance Corporation, there was a complete and public collapse of the notion that today’s large complex financial institutions could actually go bankrupt without causing a great deal of collateral damage.

In a free and fair discussion before the F.D.I.C.’s Systemic Resolution Advisory Committee, proponents of bankruptcy as a viable option acknowledged that this would require substantial new legislation, implying a significant component of government support â€" or what would reasonably be regarded as a form of “bailout” to a failing company and its stakeholders. (I’m a member of the committee, and the events took place in the first session of the committee’s public hearing.)

In other words, as matters currently stand, bankruptcy for a big financial company would imply chaotic disaster for world markets (as happened after Lehman Brothers failed). It is completely unrealistic to propose “fixing” this problem with legislation that would create a new genre of bailouts. Under current law - and as a matter of common sense - the Federal Reserve should take the lead in forcing megabanks to become smaller and simpler.

The legal authority for such action is clear. Under Section 165 of the 2010 Dodd-Frank financial reform legislation, large nonbank financial companies and big banks are required to create and update “the plan of such company for rapid and orderly resolution in the event of material financial distress or failure.” The design is that this plan - known now as a “living will” - should explain how the company could go through bankruptcy (i.e., reorganization of its debts under Chapter 11 or liquidation under Chapter 7 of the Bankruptcy Code) without causing the kind of collateral damage that occurred after the failure of Lehman Brothers.

This bankruptcy should not involve any government support. It is supposed to work for these large financial companies just as it would for any company, with a bankruptcy judge supervising the treatment of creditors. Existing equity holders, of course, are typically “wiped out” - the value of their claims is reduced to zero.

The full details of these living wills are secret, known only to the companies and the regulators. (The Systemic Risk Council, whose chairwoman is Sheila Bair, has called for greater disclosure of important details. I am a member of the council.)

But the discussion at the F.D.I.C. helped make clear that these living wills cannot be credible because the big banks are incredibly complex, with cross-border operations and a web of interlocking activities. When one piece fails, this leads to cross-defaults, the seizure of assets around the world by various authorities and enormous confusion regarding who will be paid what. When any single megabank starts to go down, others will certainly come under intense market pressure, in part because the value of their assets will fall and in part because a sense of panic will spread; this is how such crises become systemic.

All of these effects are exacerbated by the fact that these companies are also highly leveraged, with much of this debt structured in a complex fashion (including through derivatives). The bankruptcy experts at the F.D.I.C. meeting stressed these points in fascinating detail.

The proponents of bankruptcy further readily acknowledged that handling the collapse of such a company in an “orderly” fashion - i.e., without causing global panic - would require making a large amount of credit available to the relevant judge.

But who could possibly provide the amount of credit necessary to be stabilizing, particularly at a moment of systemic nervousness or potential panic? Yes, they are looking at you - or, more precisely, at the United States government, either through the Treasury Department or the Federal Reserve.

Under current legislation, providing such funding would be illegal.

It would also be beyond weird. Remember the justifiable resentment when Congress was asked to fund the $700 billion Troubled Asset Relief Program in September 2008, to be run with the Treasury - initially with very little accountability.

Now we are being asked to fund activities overseen by bankruptcy judges, who could decide, for example, to keep on current management. How would that play politically?

One argument is that such official loans would be “safe” because the government will definitely not lose the principal of its loan. But such assertions are not justified. Sometimes government emergency financial support can earn a decent risk-adjusted return, if troubled assets sufficiently recover their value. More often, the government ends up handing over a very large subsidy.

Bankruptcy cannot work for big banks at their current scale and level of complexity. It is not a viable option under current law. And changing the law to add a bailout component to bankruptcy - but only for very large complex financial institutions - does not pass the laugh test.

What then are the implications? The Dodd-Frank Act has some specific language about what happens if “the resolution plan of a nonbank financial company supervised by the Board of Governors or a bank holding company described in subsection (a) is not credible or would not facilitate an orderly resolution of the company.”

Not unreasonably, under Section 165 of Dodd-Frank, the Fed and the F.D.I.C. “may jointly impose more stringent capital, leverage, or liquidity requirements, or restrictions on the growth, activities, or operations of the company, or any subsidiary thereof, until such time as the company resubmits a plan that remedies the deficiencies.”

The company may also be required “to divest certain assets or operations identified by the Board of Governors and the corporation, to facilitate an orderly resolution.”

The retort of the big banks is, “We can skip bankruptcy and go directly to Title II resolution,” which allows the F.D.I.C. to step in and take charge of a failing financial company. But this authority, in Title II of the Dodd-Frank Act, is intended as a backup - to be used only if, contrary to expectations, bankruptcy does not work or chaos threatens.

If it is clear even before such a bankruptcy occurs that it cannot work - and this is now completely clear - then the implications of the statute are not controversial. The Fed and the F.D.I.C. must require remedial action, meaning that something about the size, structure and strategy of the megabanks must change.

This is the logic of our current situation. Section 165 is potentially valuable, but only if the relevant officials recognize this reality and act on it.