Don’t Bank on Bankruptcy for Banks

In the next month, the US Treasury Department is expected to decide whether to seek to replace the 2010 Dodd-Frank Act’s regulator-led process for resolving failed mega-banks with a solely court-based mechanism. Such a change would be a mistake of potentially crisis-size proportions. 

Yes, creating a more streamlined bankruptcy process can reduce the decibel level of a bank’s failure, and bankruptcy judges are experts at important restructuring tasks. But there are critical factors that cannot be ignored. Restructuring a mega-bank requires pre-planning, familiarity with the bank’s strengths and weaknesses, knowledge of how to time the bankruptcy properly in a volatile economy, and the capacity to coordinate with foreign regulators. 

The courts cannot fulfill these tasks alone, especially in the time the proposal under consideration has allotted – a 48-hour weekend. Unable to plan ahead, the courts would enter into the restructuring process unfamiliar with the bank. Moreover, the courts cannot manage the kind of economy-wide crisis that would arise if multiple mega-banks sank simultaneously. And they cannot coordinate with foreign regulators. 

In short, completing a proper restructuring would require contributions from regulators, including pre-planning, advice, and coordination. Yet, far from accepting these contributions, the plan would largely cut regulators out of the process. 

For example, the plan would bar regulators from initiating a mega-bank’s bankruptcy, leaving it to the discretion of the bank’s own managers. In the nonfinancial sector, failing companies often wait too long before declaring bankruptcy, so creditors may step in to do some pushing, potentially even forcing a bankruptcy of a failed firm. While bank regulators have tools to push banks similarly, their most effective one is the power to initiate a bankruptcy when it is best for the economy.

Taking this tool away could have severe adverse consequences. Bank executives, like sinking industrial firm executives, have reason to “pray and delay,” hoping that some new development will save them. But if a failing mega-bank runs out of cash during such a delay, the risk that its bankruptcy will be disorderly – as with Lehman Brothers in 2008 – rises, as does the potential that it will wreak havoc on the real economy.

The current proposal, which the US House of Representatives has already passed, has other major flaws. For starters, American mega-banks operate worldwide, typically with a significant presence in London and other financial centers. If creditors and depositors of a failed American mega-bank’s foreign affiliate run off with the cash they held there, or if a foreign regulator shuts down that affiliate, the US bank would be in an untenable position. Yet courts cannot negotiate understandings with foreign regulators. American regulators can, but only if they can control the timing of the bankruptcy, and otherwise engage in the process.

The rest of the article by Mark Roe is available here.

Mark J. Roe is the David Berg Professor of Law at Harvard Law School.