Financial Scholars Oppose Eliminating “Orderly Liquidation Authority” As Crisis-Avoidance Restructuring Backstop

Mark Roe is a professor at Harvard Law School This post summarizes the text of a letter by Professor Roe and Professor Jeffrey N. Gordon of Columbia Law School to the chairs and ranking members of the Senate and House Banking and Judiciary committees and co-signed by more than 100 other academics whose work and teaching deal with bankruptcy and financial regulation. The letter explains why a bankruptcy structure should not be allowed to substitute for the Dodd-Frank Act’s regulator-driven “orderly liquidation authority. The complete letter is available here

Earlier this week, Jeff Gordon and I wrote to the chairs and ranking members of the Senate and House Banking and Judiciary committees, analyzing reasons why a bankruptcy structure should not be allowed to substitute for the Dodd-Frank Act’s regulator-driven “orderly liquidation authority.” Our letter was joined by more than 100 other academics whose work and teaching deal with bankruptcy and financial regulation.

The Financial CHOICE Act of 2017, H.R. 10, would replace the “Orderly Liquidation Authority” (“OLA”), Title II of Dodd-Frank, with a new bankruptcy procedure, the Financial Institution Bankruptcy Act (“FIBA”), as the exclusive means for addressing the failure of systemically important financial institutions (“SIFIs”). The House Banking committee reported out the bill several weeks ago. A stand-alone version of FIBA has already passed the House.

Although a bankruptcy mechanism usefully expands the channels for resolution of a failing financial firm, bankruptcy institutions alone cannot manage a full-blown financial crisis. Crisis management will need regulatory authorities. The difference in function, and the baseline uncertainty of success, could fan financial panic rather than stabilize the financial system, if there is no regulatory backup and support. While FIBA, particularly if made more robust than the current version, would be a valuable addition to the panoply of crisis tools, the economy and the financial system will still need OLA to make FIBA work. Hence, substituting FIBA for OLA risks exacerbating a financial crisis like that which the country faced in 2008-2009.

The letter describes four general reasons why bankruptcy cannot substitute for OLA: planning and backup, international coordination, coordinated response and liquidity provision.

Planning and backup. For FIBA to function properly, it needs institutional supports that only OLA and its related rules now provide. H.R. 10 contemplates that a failed SIFI would land in a bankruptcy court and be resolved and stabilized within 48 hours; for FIBA to have the possibility of success, a “FIBA-friendly” capital structure must be in place. That would need to be done before a bankruptcy and normally it would be the regulators who verify the capital structure’s adequacy through the OLA-based “living will” process.

Bankruptcy can routinize restructuring, particularly for bank holding companies that may fail for firm-specific reasons not embedded in a broader crisis. But it may not succeed and OLA needs to remain in place as a backup.

International coordination. Lehman Brothers’ bankruptcy in 2009 triggered or exacerbated a world-wide financial panic in significant part because of the lack of international coordination. Under Dodd-Frank’s OLA, the FDIC will have prior understandings with foreign regulators and can seek to manage or avoid global financial contagion. A U.S. bankruptcy court will lack deep prior relationships or the authority to reach understandings with foreign regulators in advance of a bankruptcy filing. American regulators will need to help make foreign regulators comfortable with the bankruptcy process. But repealing OLA and its supports would undermine that objective because it would remove an essential American backstop in the event that a FIBA restructuring is unsuccessful.

Coordinated response. A financial crisis that threatens the economy will involve multiple institutions failing or tottering simultaneously. The American economy will need a coordinated response, if the entire financial system suffers a panic or lack of liquidity. Bankruptcy judges cannot provide that coordinated response. They cannot caucus and decide how to handle multiple bankruptcies in a way that best stabilizes the economy. Bankruptcy courts have neither a mandate, nor the proper experience, nor the staff needed to design a plan to protect the financial system as a whole. Only the regulators can do that, and OLA and its supporting provisions are necessary for the regulatory effort.

Liquidity. Similarly, liquidity can be crucial to stabilizing financial firms in a crisis. But the bankruptcy judge cannot provide liquidity to the system or to a tottering SIFI. And, if financial distress is widespread, private markets cannot provide that liquidity either. Under the Dodd-Frank Act, the only source of public liquidity support for a failing financial firm would be through an FDIC receivership.

* * *

OLA issues. Two of the primary objections voiced in Congress to OLA lie in (1) the view that government loans under OLA will amount to a “bailout,” even though the Act requires that the loans be backed by the assets of the firm, and that they be recovered in the resolution process or from the largest members of financial industry thereafter, and (2) the discretion that OLA gives the regulators to provide similarly situated creditors with different recoveries. We understand these concerns, but any reform effort here should preserve OLA’s advantages. For example, without endorsing the following, those concerned with payback could mandate above-market penalty rates in any government liquidity lending or could delete the authorization for differential recovery, rather than by a baby-with-the-bath-water jettisoning of OLA.

* * *

Local weaknesses in FIBA. FIBA is not as robust as one would hope a bankruptcy channel would be. At least three bases for its lack of robustness are in play.

First, FIBA gives the SIFI and its executives exclusive control over when to initiate a FIBA proceeding. But bank executives have reason to wait, in hope, however small, of the bank recovering. Yet while waiting, the SIFI may lose whatever liquidity buffer it had, making it harder for bankruptcy to succeed and raising the stark choice between a bailout and a chaotic failure. Thus the regulators need authority to choose the timing of a FIBA proceeding.

Second, FIBA is silent on how the SIFI would be restructured if the 48-hour period runs out without a successful resolution. FIBA is not a general vehicle for financial firm bankruptcies, but a mechanism to effectuate a particular kind of quick restructuring. If it fails, FIBA provides no alternative.

Third, American bankruptcy courts currently lack the full judicial power of the United States, which will add uncertainty to the bankruptcy process in a crisis.

* * *

Conclusion. Bankruptcy cannot substitute for resolution via the Orderly Liquidation Authority administered by the FDIC. It can, in contrast, provide an additional, useful resolution channel.

Repealing OLA and its supporting provisions and replacing it with FIBA would be a serious disservice to the stability of the American economy.

Jeff Gordon’s and Mark Roe’s letter to the Banking and Judiciary committees chairs and ranking members can be found here.

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