Big Banks and the Failure of Bankruptcy

Publication: New York Times

Author: Simon Johnson

12/19/2013 —In modern American political discourse, it is unusual to see ideas explode before your very eyes. It’s much more typical for bad ideas to drift away quietly – or alternatively to stick around, year after year, despite being completely at odds with the facts.

On Dec. 11, at a meeting at the Federal Deposit Insurance Corporation, there was a complete and public collapse of the notion that today’s large complex financial institutions could actually go bankrupt without causing a great deal of collateral damage.

In a free and fair discussion before the F.D.I.C.’s Systemic Resolution Advisory Committee, proponents of bankruptcy as a viable option acknowledged that this would require substantial new legislation, implying a significant component of government support — or what would reasonably be regarded as a form of “bailout” to a failing company and its stakeholders. (I’m a member of the committee, and the events took place in the first session of the committee’s public hearing.)

In other words, as matters currently stand, bankruptcy for a big financial company would imply chaotic disaster for world markets (as happened after Lehman Brothers failed). It is completely unrealistic to propose “fixing” this problem with legislation that would create a new genre of bailouts. Under current law – and as a matter of common sense – the Federal Reserve should take the lead in forcing megabanks to become smaller and simpler.

The legal authority for such action is clear. Under Section 165 of the 2010 Dodd-Frank financial reform legislation, large nonbank financial companies and big banks are required to create and update “the plan of such company for rapid and orderly resolution in the event of material financial distress or failure.” The design is that this plan – known now as a “living will” – should explain how the company could go through bankruptcy (i.e., reorganization of its debts under Chapter 11 or liquidation under Chapter 7 of the Bankruptcy Code) without causing the kind of collateral damage that occurred after the failure of Lehman Brothers.

This bankruptcy should not involve any government support. It is supposed to work for these large financial companies just as it would for any company, with a bankruptcy judge supervising the treatment of creditors. Existing equity holders, of course, are typically “wiped out” – the value of their claims is reduced to zero.

The full details of these living wills are secret, known only to the companies and the regulators. (The Systemic Risk Council, whose chairwoman is Sheila Bair, has called for greater disclosure of important details. I am a member of the council.)

Read the full article, Big Banks and the Failure of Bankruptcy, on the New York Times website.