A Functional Analysis of SIFI Insolvency

Since the disgrace of Lehman, the question of how to handle failing SIFIs has been quite vexed. On the one hand, governmental rescue of shareholders and other investors is beyond annoying, and there is some intuitive sense that if management does a poor job, they and their investor backers should face the consequences, just like any other firm. That bank managers would have the temerity to pay themselves large bonuses shortly after a taxpayer rescue only emphasizes the point.

On the other hand, there is a widespread understanding that a large bank, or a sufficiently interconnected one, is not quite like Kmart, Enron, or even American Airlines, in that when the bank fails, it tends to take a large chunk of the economy along with it. Pre-failure regulation can mitigate some of the effects, but by the time we get to insolvency – or ‘financial distress’ – the regulatory string has pretty much played out. And in the end, we have trouble deciding if we really mean to treat large financial institutions like normal failed firms.

In A Functional Analysis of SIFI Insolvency, I argue bank insolvency uses a lot of the language of ‘normal’ insolvency. But bank resolution is not the same as chapter 11, or any other business insolvency process.  Bank insolvency is about special priorities, and protecting special classes of creditors from the effects of insolvency, whereas corporate bankruptcy is about creditor equality and bargaining. Too often we let the similar language confound the analysis.

All of the ‘super chapter 11’ or ‘chapter 11 for banks’ proposals – including the actually enacted Orderly Liquidation Authority (OLA) – attempt to put a judicial gloss on the policy and political process that is bank insolvency. Some, like the Choice Act, appear aimed at moving policy choices away from regulators, by pretending to give power to judges, while actually moving policy choices to private actors.

It is thought that this judicial veneer will provide a kind of legitimacy to bank insolvency, that proponents believe was lacking in the recuse efforts in 2008. But if taken seriously, the judicial role is entirely incompatible with efforts to contain a systemic crisis. Moreover, the veneer is quite apt to crack in any event: consider the broad role played by the U.S. and Canadian governments in the automotive bankruptcy cases, which were at best marginally systemic debtors.  Somewhat confusingly, many of the critics of those cases nonetheless support some form of chapter 14.

If we do not take the judicial role in bankruptcy for banks seriously, and see it as instead a smokescreen, the conclusions are even more disturbing. At best the Choice Act, and proposals like it, are little more than disguised power grabs by insiders, designed to use rule of law concerns as a cover for a deregulatory agenda. When an actual systemic crisis comes, it seems inevitable that the need for governmental assistance will arise yet again, and we will be right back where we were in 2008.

Ultimately, after nearly a decade of waffling between ‘special’ and ‘normal’ bankruptcy for banks, I believe we are now ready to build upon what we have learned and to take the necessary further step:  stop feigning that bank insolvency can or should happen in bankruptcy court.

Stephen J. Lubben holds the Harley Washington Wiley Chair in Corporate Governance and Business Ethics at Seton Hall University, School of Law.