Mark Roe 18 Oct 2017 05:37pm

Don't bank on bankruptcy for banks

Next month, the US Treasury Department will decide on the future of the 2010 Dodd-Frank Act’s regulator-led process for resolving failed mega-banks.

It is considering replacing it with a solely court-based mechanism, which would be a mistake of potentially crisis-size proportions.

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 its 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 48-hour weekend the proposal suggests. Unable to plan ahead, the courts would enter into the restructuring process unfamiliar with the bank. Moreover, they could not coordinate with foreign regulators or manage the economy-wide crisis that would arise if multiple mega-banks sank simultaneously.

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 and leave it to the discretion of the bank’s own managers. In the non-financial sector, failing companies often wait too long before declaring bankruptcy so creditors may step in to do some pushing, potentially even forcing the 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,” in the hope 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 rises – as with Lehman Brothers in 2008 –,and so 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 authorised 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 and the government must serve as the lender of last resort. To play that role well, the government must be deeply involved in the bankruptcy process to 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, often 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 could control the timing of the bankruptcy and otherwise engage in the process.

The current bankruptcy bill is useful but not robust. It would not allow full-scale bankruptcies where failing operations are closed under the court’s aegis, viable operations are sold and debts restructured up and down a company’s balance sheet. Rather, the current proposal envisages a limited weekend restructuring, requiring a precise loan structure to 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 reopen 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, however it has never been tried. To have any chance of re-opening on Monday morning, a bankrupt bank’s debt would already have to be structured in such a way that a bankruptcy court could eliminate it over a weekend.

That said, bankruptcy judges would have no knowledge in advance of a bank’s debt and would need more than a weekend to determine whether it could be properly stripped out. Government regulators, on the other hand, could do this in advance, however 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 the financial system will need backup if a failing mega-bank cannot open on Monday morning. As the proposal stands, if the weekend restructuring fails the absence of a regulatory safety net could result 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 develop a routine process for restructuring banks as they did with airline restructurings. But we should be wary about relying on them 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.

Copyright: Project Syndicate, 2017.