Don’t Bank on Bankruptcy for Banks

Yes, creating a more streamlined bankruptcy process can reduce the decibel level of a bank's failure, and bankruptcy judges are experts at important restructuring tasks. But there are critical factors that cannot be ignored. Restructuring a mega-bank requires pre-planning, familiarity with the bank's strengths and weaknesses, knowledge of how to time the bankruptcy properly in a volatile economy, and the capacity to coordinate with foreign regulators.

The courts cannot fulfill these tasks alone, especially in the time the proposal under consideration has allotted – a 48-hour weekend. Unable to plan ahead, the courts would enter into the restructuring process unfamiliar with the bank. Moreover, the courts cannot manage the kind of economy-wide crisis that would arise if multiple mega-banks sank simultaneously. And they cannot coordinate with foreign regulators.

In short, completing a proper restructuring would require contributions from regulators, including pre-planning, advice, and coordination. Yet, far from accepting these contributions, the plan would largely cut regulators out of the process.

For example, the plan would bar regulators from initiating a mega-bank's bankruptcy, leaving it to the discretion of the bank's own managers. In the nonfinancial sector, failing companies often wait too long before declaring bankruptcy, so creditors may step in to do some pushing, potentially even forcing a bankruptcy of a failed firm. While bank regulators have tools to push banks similarly, their most effective one is the power to initiate a bankruptcy when it is best for the economy.

Taking this tool away could have severe adverse consequences. Bank executives, like sinking industrial firm executives, have reason to "pray and delay," hoping that some new development will save them. But if a failing mega-bank runs out of cash during such a delay, the risk that its bankruptcy will be disorderly – as with Lehman Brothers in 2008 – rises, as does the potential that it will wreak havoc on the real economy.

The simple fact is that government regulators can do things that courts cannot. Courts lack the staff and expertise to come up with a nation-wide recovery plan. Moreover, they cannot lend to a cash-poor wobbly bank until it can stand on its own. The government can do that – and it can make sure that either the bank will repay the loans (by getting good collateral) or that the financial sector overall will cover the repayment (as Dodd-Frank authorized and required).

When courts preside over nonfinancial bankruptcies, they depend on private lenders to provide emergency liquidity. But in a financial crisis, weakened banks cannot lend, meaning that the government must serve as the lender of last resort. And to play that role well, the government must be deeply involved in the bankruptcy process, so that it can jump in if needed.

The current proposal, which the US House of Representatives has already passed, has other major flaws. For starters, American mega-banks operate worldwide, typically with a significant presence in London and other financial centers. If creditors and depositors of a failed American mega-bank's foreign affiliate run off with the cash they held there, or if a foreign regulator shuts down that affiliate, the US bank would be in an untenable position. Yet courts cannot negotiate understandings with foreign regulators. American regulators can, but only if they can control the timing of the bankruptcy, and otherwise engage in the process.

To be sure, the bankruptcy bill now in play is useful. But it is not robust. It would not allow broad-spectrum, full-scale bankruptcies, in which failing operations are closed under the court's aegis, viable operations are sold, and debts are restructured up and down a company's balance sheet. Rather, the current proposal envisages a limited-scale weekend restructuring, requiring that a precise loan structure be put in place years ahead of time. The bank would be closed on Friday evening, unburdened of pre-positioned evaporating debts over the weekend, and reopened on Monday morning, without (in the best-case scenario) needing a government bailout.

If successful, this kind of rapid-fire bankruptcy process would be valuable. But it has never been tried. To have any chance of re-opening on Monday morning, a bankrupt bank's billions of dollars in long-term debt would already have to be structured in such a way that a bankruptcy court could eliminate it over a weekend.

But bankruptcy judges would have no knowledge in advance of a bank's debt, and they would need more than a weekend to determine whether that debt could be properly stripped out. Government regulators, on the other hand, could do this in advance. And yet, under the current proposal, their official means of doing so would be sharply rolled back.

Bankruptcy, if it works, is a good way for a failing firm to restructure or shrink. But if a failing mega-bank cannot open on Monday morning, the financial system will need backup. Under the current proposal, the absence of a regulatory safety net could result, if the weekend restructuring fails, in a global chaotic free-for-all, just like the one that followed the 2008 Lehman Brothers bankruptcy.

Maintaining financial stability in a crisis is too important for us to pin our hopes on a narrow bankruptcy channel. The courts can help, especially after they have developed a routinized process for restructuring banks, as they have done with airline restructurings. But we should be wary about relying on courts to do things they have never been asked to do before.

The House already voted, precipitously, to replace the regulator-led restructuring system with a weaker court-led setup. Let's hope that wiser heads at the Treasury Department prevail.

A letter to Congress with a similar conclusion was signed by 120 academics with expertise in bankruptcy, banking regulation, finance, or all three.

Mark Roe is a professor at Harvard Law School.

© Project Syndicate 1995–2017