Bankruptcy for Banks: A Sound Concept That Needs Fine-Tuning

Mark J. Roe is the David Berg Professor of Law at Harvard Law School, and David A. Skeel is S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School. This post is based on a recent op-ed article by Professors Roe and Skeel published today in the New York Times DealBook, available here.

The House of Representatives is pushing to enact a bankruptcy act for banks.

It has passed a bankruptcy-for-banks bill, sent it to the Senate, and now embedded it in its appropriations bill, meaning that if Congress is to pass an appropriations bill this year, it may also have to enact the bankruptcy-for-banks bill.

Is that a good idea?

In concept, bankruptcy for banks makes sense: Why should they get the benefits of government bailouts that industrial companies rarely receive? The answer usually is that a bank failure can bring down the economy, while an industrial failure cannot. But if banks can be reorganized in bankruptcy, the possibility of a win-win result is in the cards. We could restructure a big bank to stop it from damaging the economy, but without having to bail it out.

The two of us support this concept—and indeed one of us worked extensively with the Hoover Institution to draft such a bankruptcy proposal. But the bill in play has several dangerous features that could make bailouts more likely, not less likely.

First and most problematic, only the bank and not the regulator can make the bankruptcy happen. If the regulators think that a bankruptcy is needed, but that a bailout or alternative resolution process is not needed, they cannot directly force a filing.

Typically, creditors of a failing company can force a bankruptcy and the United States is effectively a major creditor for banks—guaranteeing deposits and more. Earlier bankruptcy-for-banks proposals had the regulators able to put a big troubled bank into bankruptcy, but the House bill mistakenly does not. Regulators can resolve banks under the Dodd-Frank Act, but can do so only under specific conditions that may take time to invoke.

True, regulators can pressure bank managers to reluctantly file, but the regulators may have to concede conditions to bank executives to make them file quickly; if the bank does not file quickly, the regulators may decide that to save the economy, they have to bail the bank out. In the extreme case, bank management may just refuse to file for bankruptcy.

Second, the bill broadly exempts bank executives from lawsuits and liability for pre-bankruptcy actions. Banking law anticipates that bank officers and directors could be held personally liable for gross negligence in mismanaging the bank. With executives fearing lawsuits, the thinking was that they would run risky, wobbling banks more soundly. The House bill exempts bankers from liability not just for the actual filing for bankruptcy—an exemption needed to encourage them to file voluntarily when needed, and which we support—but also for any actions taken “in connection with” the filing.

As lawyers know, the phrase “in connection with” has no sharp boundary; it could readily shield the bankers from liability for serious errors that made the filing necessary. After all, “everything is connected to everything.”

Third, the bankruptcy bill contemplates only one kind of bankruptcy: one where all of the bank’s derivatives contracts and short-term funding, or repo, are fully paid off, with longer-term creditors being hit to support the short-term debt. This mechanism is potentially a good way to restructure a failed bank and stop a run on the banking industry more broadly. Today’s bankruptcy law allows those with derivatives and repo contracts with the bank to terminate them as soon as the bank files for bankruptcy. This wide termination when Lehman Brothers filed for bankruptcy in 2008 caused havoc in financial markets around the world.

The House bill is putting all its bets on this mechanism of fully paying off derivatives and repos in a 48-hour bankruptcy. But such a rapid-fire bankruptcy has never before been tried, and under the bill, it must be completed in 48 hours—faster than almost any bankruptcy on record.

As military generals know, no battle plan survives first contact with the enemy; and as financial policy makers in and out of Congress should understand, no financial plan will survive first contact with a crisis. A viable bankruptcy structure needs to have a backup to the House bill’s near-overnight restructuring plan, because it may not work. One piece that is needed, in case a quick bankruptcy does not work, is a mechanism to smoothly disassemble a supposedly “too big to fail” bank so that it does not drag the economy down with it. That would need a provision preventing the bank’s creditors from terminating its derivatives and short-term funding contracts until the derivatives book can be disassembled in an orderly way and the short-term financing wound down.

The good news is that the core concept behind the bill—bankruptcy for banks—is sound. Although the problems we outlined are fundamental, they can be fixed with more thought and straightforward changes. But if these adjustments are not made, the system would depend on a quick bankruptcy that might not work. If it does not, we fear that the House’s proposed bankruptcy bill would then leave only one alternative for the regulators: to bail out the failed bank and its executives.

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