Bankruptcy Versus Bailout of Socially Important Non-Financial Institutions

Systemically important financial institutions are broadly considered to pose a risk to the entire economy upon failure. Thus governments act upon their failure, providing them with an implied insurance policy for ongoing liquidity. Yet governments frequently provide de facto liquidity insurance for non-financial institutions as well. For example, recently in the U.K., 35 hospital trusts were sharing £536 million in non-repayable bailouts in order to keep services running smoothly during 2013-2014. A decade earlier, a federal bankruptcy judge approved California’s multibillion-dollar bailout of Pacific Gas & Electric Corporation. In an effort to stabilize and sustain air transportation after 9/11, the U.S. Congress passed the Air Transportation Safety and System Stabilization Act, which provided the airline industry with financial aid valued at as much as $10 billion. In all of these cases, taxpayer money was used to rescue non-financial institutions.

In the failure of non-financial institutions, size cannot justify governmental bailouts. No one would consider bailing out a corporation providing luxury designer apparel brands with a huge consolidated assets portfolio. Yet organizational failure may impose significant risk to social stability beyond the financial sector. Our lives are heavily influenced by and dependent on the ongoing provision of products and services by private organizations. Banks are essential for the provision of monetary services and credit. Other organizations supply the public with energy, electricity and gas; provide public transportation; run major hospitals; and much more. Social stability relies heavily on sustaining ongoing organizational services to retail consumers. Stability is the new underlying narrative of financial regulation. The Dodd-Frank Wall Street Reform and Consumer Protection Act, Basel III, the Financial Stability Board and the leaders of central banks focus extensively on promoting financial stability, not only through macroeconomic policy but also through the regulation of corporate governance for individual corporations considered systemically important financial institutions. However, little attention is paid in the literature to the effect on stability in the event of the financial failure of socially important non-financial institutions.

This essay proposes a framework for the identification of socially important non-financial institutions (SINFIs). Governmental insurance for corporate solvency is required when sustaining the provision of products or services by the failing corporation is vital for the adequate functioning of society. Governments should sometimes intervene to sustain the provision of essential products and services but need not intervene with public funding to reduce haircuts for institutional creditors or derivative obligations. Based on the analysis of three examples of governmental bailouts of non-financial institutions, the essay proposes a framework for the assessment of social importance, composed of a two-layer test. The first layer is identification of the essential markets required for sustaining lives and maintaining social stability; the second layer is identification of the particular organizations providing these essential services as situational monopolies, that cannot be substituted for by consumers or can be substituted for only with substantial switching costs. Sustaining the provision of services or products by the socially significant non-financial firm becomes a matter of public concern because it provides products or services that are deemed to be part of the social contract, and because its consumers are facing high or inapplicable switching costs for its essential services.

The essay argues that the failure of socially significant non-financial institutions poses a risk to social stability, creating a category of too-important-to-fail industrial firms. Liquidity distress for a socially significant non-financial institution is unlikely to be resolved efficiently through bankruptcy, not only because of the lengthy procedure for solving the operating contingency and ensuring continued service, but also because sustaining the provision of service by the socially significant firm imposes significant positive externalities on the general public, rendering the main features of bankruptcy: namely, debtor-in-distress rules and the ability to sell assets free and clear of all liens, sub-optimally efficient, as the potential private investor is unlikely to capture the full value of investment in the socially significant firm upon its failure. Thus, in a distressed socially important institution, both the likelihood of new investment opportunities and their potential terms are expected to be sub-optimally valued, and public finance is likely to be required. However, the infusion of public capital need not be limited to a governmental bailout, and using bankruptcy is possible with the Treasury assuming the role of debtor-in-possession financier.

Finally, the essay offers an analysis of the unique structural characteristics of the socially important non-financial institution. As situational monopolies of essential markets, too-important-to-fail firms induce a behavioral market failure and are prone to unwarranted expansion. The elevated probability of rescue in case of failure distorts the organizational incentives of the SINFI’s management well before failure occurs, increasing the taste for leverage and excessive risk taking. Further, the incentives for empire building are enhanced in SINFIs, where corporate governance pressures for mitigating agency costs are weaker.

Socially important non-financial institutions are the most important organizations in our lives, the organizations upon which we depend for social stability. These firms become too-important-to-fail because their unique position within the market makes their retail consumers utterly dependent upon their continuous service. An uninterrupted service by SINFIs is part of the social contract, an inherent expectation of our civil life. This essay identifies the category of socially important non-financial institutions, shows why they are likely to require rescue funding upon failure, and portrays their structural degradation and unique corporate governance. Policy questions in acting upon these criteria open many additional research directions in corporate law, corporate governance and antitrust policy, to be further explored in future works.

The full article is available for download here.