May 2, 2010 | Commentary on Financial Regulation

Bankruptcys Place In Financial Reform

Driving the push in Washington for new financial regulations is a simple question: Is it possible for a large firm to fail without endangering the whole economy? The answer is yes. But how?

Imagine a process that allows a failing firm to wind down its financial affairs in an orderly way, without unnecessary collateral damage. That operates free of political pressures and special-interest lobbying. That's handled by professionals who understand complex financial arrangements, not bureaucrats who dive for a dictionary when "derivatives" are mentioned.

Actually, it's not hard to imagine at all. We're not talking about a new exotic remedy. We're talking about bankruptcy.

Which is not to say that no fixes are necessary. No, the bankruptcy that works so well today for almost all companies doesn't apply to large financial institutions such as AIG, Citibank and Bank of America. There's no system in place for their orderly restructuring.

That's why, when the 2008 meltdown hit, the federal government ended up giving them hundreds of billions of tax dollars in capital infusions and loans.

Unfortunately, the main piece of legislation being debated in Washington, a bill sponsored by Sen. Christopher Dodd, won't help matters. It would give power to wind down a failing firm to the Federal Deposit Insurance Corp. — as if dealing with a large financial institution in distress is like handling a small bank failure. It isn't.

Indeed, the Dodd bill doesn't take the most obvious step needed to prevent a recurrence: modernize bankruptcy laws to create an expedited way to restructure and close large financial firms.

Specifically, we need to add a chapter to the bankruptcy code to meet the special circumstances of "too big to fail" financial institutions.

The key changes to the bankruptcy statutes would be to give courts the ability to deal with a very different asset mix than is found in traditional companies. The court would need to be able to act very quickly to preserve asset value in the face of clauses in lending contracts that allow lenders to take immediate possession of firm assets upon a bankruptcy filing without going through a legal process to do so.

The court should be able to wind down the firm as quickly as possible to minimize the impact on the financial system. But it also should have the flexibility either to liquidate the firm totally or to restructure and sell it.

Handling this process through bankruptcy rather than with regulators has two additional advantages. First, the courts already have experience with large and complex bankruptcies. Second and equally important, the courts will be impartial and free of the inevitable politicization that would accompany a government agency's involvement in the process.

A firm also should be allowed to seek the advice of the court, appropriate functional regulators, and others before deciding whether to file for bankruptcy. These consultations should be strictly confidential, and be publicized only after the firm seeks the protection of a bankruptcy court or is brought before the court by regulators.

As in other bankruptcy proceedings, the process shouldn't include public funding. The failing institution's investors and creditors should bear any losses. Additional funds necessary to resolve the failing financial institution would come from other private-sector providers, whether through secured loans or from money obtained by selling certain parts of the failing firm.

A tough-talking approach like the one in the Dodd bill may sound correct — at first. But if we want a solution that actually works, beefed-up bankruptcy is the way to go.

David John is is senior research fellow in retirement security and financial institutions at The Heritage Foundation.

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies

First appeared in the Hartford Courant