Bankruptcy Reform and Financial Crises

Mike Konczal has a fascinating idea that he expands in an interview: that the 2005 bankruptcy reform may have contributed to the severity of the financial crisis. The idea is that a change in the law expanded exemptions for derivatives during bankruptcy proceedings. This allowed derivative counterparties to end contracts and seize collateral as soon as bankruptcy was filed, moving to the head of the line among creditors.

There were several problems with this. First, this created incentives to restructure normal contracts, such as agreements to supply fuel to an airline company, in the form of swaps or derivatives. This was a win-win for creditors and debtors. Creditors were assured easy contract termination, even if the firm entered bankruptcy. Debtors were not generally required to post collateral for their contracts, allowing them to operate with a leaner capital structure.

Second, these rules expanded to define mortgage-backed securities as repos for the purposes of the safe harbor. This was potentially a huge change. Gary Gorton has argued that the demand for short-term securities, fulfilled by mortgage-backed securities, was fueled by the demand for information-insensitive, safe assets. Andrei Shleifer has suggested that these sorts of new, exotic securities were mispriced. While both of these may be a part of the story; there is another interpretation. The surge in securitization can be seen as a form of regulatory arbitrage designed to create short-term funding that would hold up in bankruptcy court. Without the penalty of potentially losing assets during bankruptcy, lenders were more willing to provide short-term funding to over-levered Investment Banks.

As Mike’s interlocutor points out: for non-bank institutions, this change was not the end of the world. Quick liquidation of existing contracts is akin to the Chapter 7 process (rather than the lengthy reorganization of Chapter 11). There are often advantages to slowing down the bankruptcy process, but small firms can be liquidated in an orderly manner.

The same is not true for banks. The special treatment of repos and derivatives in bankruptcy resulted in early termination and seizure of contracts by bank counterparties during moments of crisis or bankruptcy. The going-value of a bank—the excess value they have above and beyond the market value of its assets—is crucially dependent on its solvency and liquidity. Illiquid banks, by virtue of their leverage, are forced to sell their assets at fire sales, which can lower prices, which can lower the value of their assets further in a destructive spiral. Ensuring that certain forms of short-term funding and derivatives went to the front of the line in the Lehman case all but ensured that its bankruptcy would be a disaster.

The unintended systemic consequence of this treatment of bankruptcy was illustrated once before, during the failure of Long Term Capital Management. Intervention by the Federal Reserve happened precisely because regulators were worried that the failure of LTCM would cause a disorderly liquidation; a liquidation that would be worse exactly because derivative contracts could be terminated early.

As Mark Roe points out, the exemption that derivatives and repos enjoyed also warped their incentives to monitor the risk-taking going on at Investment Banks. The rule also possibly artificially increased the amount willing to be lent to banks, and gave them lower borrowing costs.

All of this points to a need to reform the bankruptcy code in order to treat derivatives on par with other claims. While legislative and popular pressure has focused on derivatives as being inherently bad, it would be better to fix legislation that encourages the over-use of derivative contracts and risk-taking; rather than leaving these elements in place, and hoping that other regulatory fixes elsewhere would solve the problem.

Revisionism on Deposit Insurance

One of my personal pet peeves is the existence of Federal Deposit Insurance. Arnold Kling well characterizes the point of view I believe ("revisionist") against the standard position:

The standard view is that banking in a free market is inherently fragile, which makes deposit insurance necessary. In fact, some would argue that the concept of insurance needs to be extended to the so-called "shadow banking system." I think of Perry Mehrling and Gary Gorton as being in that camp.

The revisionist view is that deposit insurance is a case of the government concocting a solution to a problem that was created by government in the first place. That is, the U.S. banking system was unstable due to regulations that promoted small, local banks and inhibited the creation of diversified nationwide banks. Had banks been allowed to branch across state lines or had national bank holding companies been allowed to grow naturally, then (according to this argument) we would have seen few bank failures, even in the 1930's. Hence, there would be no need for deposit insurance.

There are several good reasons to argue against the traditional view that banking is naturally risky and therefore requires deposit insurance:

1. Maturity Mismatching is unnecessary. Japan, for instance, has historically adopted the view that lending of a certain type and duration should be matched with a liability similarly constructed. So instead of using flighty deposits to fund long-term projects, your deposits are funneled into assets with low risks and returns. Without crossing maturity lengths, the possibility of a bank run gets a lot smaller.

2. Absurd populist demands of the 19th century limited the number of branches a given bank could open. That resulted in a very geographically fragmented banking system prone to crisis every time agricultural yields fell in a given area. As a result, banks failed often and the entire business cycle was highly volatile.

Canada illustrates that the problem was exactly those banking restrictions, not banking in general. Canada's banking laws were far more permissive in terms of where banks could open branches, and the country developed a highly concentrated, well-regulated system of banks. By drawing on the deposits of an entire country, tiny shocks were not enough to force bank failure. In fact, the country barely experienced bank failures, and never saw banking panics -- even during the Great Depression. They did not even bother instituting deposit insurance until 1967. Canadian banks again outperformed American ones in the most recent crisis.

3. The past experience of deposit insurance before the 1930s was mixed. As Amar Bhide notes in A Call for Judgement, many of the state deposit plans performed quite badly through the Great Depression, frequently proving insufficient to cover all losses. The Indiana plan worked best by making other bank branches jointly responsible for the failure of a given bank. The national clearinghouse model also provided another vehicle for banks to collectively guarantee their deposits and prevent a panic, without requiring insurance. This sort of collective monitoring was not followed by other state plans, which performed poorly in sheltering depositors from bearing bank losses. Rather, by pushing some of costs of risky lending onto another party, they may have further encouraged bad lending and hastened banking crises.

The eventual adoption of FDIC insurance during the Great Depression drew on the disastrous experience of the standard issue insurance plans, as opposed to the successful mutual responsibility plans. It was was opposed by several interests -- including big banks, FDR, and the Treasury. Many of these actors were concerned by the poor performance of state insurance plans. However, federal insurance had the benefit of further entrenching the power of small banks, which would otherwise be a competitive disadvantage relative to their larger banking peers. We adopted the FDIC not as a part of a well-thought out plan to stem banking problems based on past evidence; but rather to satisfy the small bank lobby responsible for banking fragility in the first place.

4. The moral hazard aspects of deposit insurance have been tested internationally, and the results are fairly negative. A study by Aslι Demirgüç-Kunt and Edward J. Kane finds that countries with the highest coverage levels of deposit insurance are five times as likely to have a financial crisis as countries with low coverage limits. Better institutional quality (presumably leading to more prudential regulation) reduces the moral hazard caused by deposit insurance, but not entirely.

5. It's not clear that a banking crisis from one firm necessarily spreads to other, healthy, banks. The key test for this was the Great Depression, and my understanding is that studies point both ways on this.

At this point, FDIC insurance seems here to stay -- though it's worth pursuing policies to limit the amount of money covered by the insurance (say, at $100,000 per taxpayer, rather than $100,000 at each bank you have money at) or increasing bank co-insurance plans.

But this debate remains very relevant in thinking through the Shadow Banking crisis. One school of thought, best represented by Gary Gorton, feels that the problem there is similar to the issue in normal banking, and the solution lies in making repos -- the equivalent of deposits for Shadow Banks -- effectively riskless. Rather, the perspective above would point out the flaws in maturity mismatching generally, and would push against the institutional aspects of banking that make it more fragile by hiding risks and promoting moral hazard -- for instance, skewed salaries, the end of the partnership structure, and the bankruptcy treatment of derivatives.

Bankruptcy is Always an Option

I’m very sympathetic to Mike Konczal’s argument against bankruptcy as an option for winding down systematically important financial institutions. We tried bankruptcy for Lehman Brothers, and the consequences were pretty bad (no matter what John Cochrane says). I think it’s pretty clear that bankruptcy, as it exists today, is unsuited for large financial institutions, as they exist today.

Still, I’ve slowly come to the conclusion that a prepackaged form of bankruptcy, under FDIC auspices, has a lot of advantages. It would require some tinkering with the Bankruptcy Code and how financial firms work; but has the advantage of moving us to a world in which financial firms can fail, discharge liabilities in an orderly fashion, and open their doors the next day.

We have some precedent for this, by the way. When WaMu failed; the FDIC stepped in; wiped out shareholders, and sold off the bank to JP Morgan without hurting grandma's deposits. And if you look at the canonical treatments of this issue in corporate finance--it's clear what to do. When firms become insolvent, you need to write down debt and give debt-owners equity ownership.

Here’s how this sort of framework would work—I’m working through proposals advanced by Garrett Jones, Wilson Erving, and Paul Calello. When a firm signs up for bankruptcy; regulators would come in and start by immediately writing off all equity and marking down assets. Then, the bank is recapitalized by writing off junior debt, and then as much senior debt as required, and converting these into equity. Basically, we would by fiat say that all bank debt is really convertible capital, triggered by bankruptcy.

To take a concrete example--let's work through Bank of America's latest 10-Q. I suspect they are insolvent now anyway, as are many large banks--more on this later. You'll see ~2.3 trillion in assets. On the liability side, you have ~1 trillion in deposits, ~500 billion in long-term debt, and about 600 billion in other liabilities. The stocks are worth about 230 billion.

Let's say BofA runs into some trouble, and their shareholder equity (stocks) plummets to ~75 billion. For fun, let's say that they have about the same in losses. They enter bankruptcy. All a judge has to do is say--write down that equity! Those stocks are now worthless. Next, we'll wipe down, say, half of that long-term debt and turn it into equity in the new company. If that's not enough, we'll go after the other liabilities or more debt. We can go after subordinated debt harder than we hit senior debt.

That's it. Bank of America opens the next day having written down large portions of their toxic loans, and is recapitalized by their long-term lenders. We can now sell this entity off to whoever wants it, or they can stick around and make new loans. Grandma keeps her savings account as well--though, in a perfect world, I'd take a haircut of that too if grandma has more than, say, $50,000 saved in FDIC institutions overall.

This proposal manages to do everything we want bankruptcy to do, while tailoring the response for financial institutions. In bankruptcy, we recognize that firms have failed, and kick out old management. Lenders take haircuts in order of seniority, but do better in bankruptcy than in liquidation. Meanwhile, these firms—now recapitalized, and without toxic assets—are free to raise further capital and lend.

When opting for a hybrid bankruptcy route, however, it’s also essential to reform the bankruptcy code to end derivative counterparties’ exemption from the automatic stay preventing collateral seizure in bankruptcy. As both Chris Papagianis at e21 and Mike Konczal have noted, this exemption reduces the incentive for the suppliers of short-term capital to shadow banks to monitor their risk-taking.

To draw an analogy; the Asian financial crisis in 1998 was sparked by the flight of short-term foreign capital, much as the Financial Crisis of 2008 was sparked by the flight of short-term repos from Investment Banks. In the Asian crisis, foreign creditors chose a short-term financing structure because that gave them an easy avenue of exit when things went south. Similarly, repo lending and derivatives took off because these contracts would not be subject to the same considerations as other contracts in the bankruptcy process. The best way to curb a risky reliance on short-term lending is to force these contracts to be treated like others in an orderly bankruptcy process.

Finally--spinning off prop trading desks and derivative dealer operations--which should be happening to a degree under the new Financial Reform bill, should probably make this easier as well. We really want our financial firms to focus on underwriting securities offerings and extending loans throughout the financial system. It's easier to work through the bankruptcy of a bank, rather than the bankruptcy of a bank which also owns a casino.

Dealing with financial companies in some manner like this is incredibly important for three reasons:

1. We finally get to make lenders pay. For instance, here is Russ Roberts:

There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks. Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar.

Well, those bondholders and lenders made plenty of money on the way up, taking risks. They need to bear those risks on the way down, instead of taxpayers. Then, maybe they will do a better job of monitoring the risk going on in financial institutions.

Lenders really are the optimal agent to handle bank monitoring, by the way. Regulators are prone to cognitive biases and regulatory capture when times are good. Owning stock in a highly levered institutions is akin to holding an option, and makes you really want to ramp up risk. Managers of firms are paid in stocks, and so also have a strong risk preferences. It's really the bondholders and depositors--who make money as long as things don't go really bad--who have the strongest incentives to watch what's going on in terms of risk-taking. But this won't happen if they get bailed out, or can handle their contracts through repos and derivatives.

2. Two is the zombie banking problem. As Anil Kashyap and others have shown, the refusal to accept banking sector losses in Japan led to a decade-long problem of “zombie banking” in which fundamentally insolvent banks lingered, without funding new investment. Saddled with liabilities, American banks are not lending. Rogoff and Reinhart, among others, have suggested that this is a large part of why recoveries from financial crises are so anemic. The Administration has argued this as well. Yet, incredibly, no one actually seems to have an idea for dealing with this debt. This was Michele Boldrin's point in his debate with Brad DeLong. It's not at all obvious that Keynesian stimulus is a valid substitute for a serious push to deal with bad debts.

2. Third is the problem of soft budget constraints. This is a concept invented by Janos Kornai initially to examine the sources of inefficiency in Communist governments. Kornai had the insight that when firms expect to be bailed out after taking large losses, they alter their behavior.
However, this logic also holds in capitalist economies for all entities—be they hospitals, government-backed mortgage giants, or large banks (or car companies, large insurance companies, airlines, money-markets, sub-national states, European countries, etc.)—that expect fiscal assistance after chronic failure. Financial institutions armed with a Too-Big-to-Fail guarantee are virtually certain to make risky investments that generate current income, with long-term costs borne by the taxpayer.

To a certain extent, the last two problems balance each other out the way our system works now. Banks may be more reluctant to lend if they retain toxic assets on their books, but may be more willing to lend if they expect to be bailed out. This is perhaps the intention of policymakers, who are eager to find ways to increase lending without forcing banks to recognize the true nature of their losses.

This is perhaps why the American response represents a substantial improvement relative to Japan. But as long as these problems remain intact, lending will remain at a knives edge caught between two politically mandated and unpleasant alternatives. It’s clear that the bailout route is a very second-best way to address problems within the banking sector, and It’s important to develop techniques for the unwinding of systemically important financial institutions that avoid creating banks that behave like those in Japan or the Soviet Union.

I don't want to exaggerate the differences between this framework and the newly-created resolution authority. As I understand it; under resolution authority, banks enter federal receivership and their books are sorted out by regulators. The process, then, resembles bankruptcy in certain respects. The big change I'd make here is simply a mandatory haircut of debt before taxpayers contribute a dime, or else mandatory convertible capital requirements triggered when resolution kicks in.

I'm sure this solution has lots of problems as well. But it's not obvious that these problems are worse than the ones we already have. And you only need to write a few pages of legislation to get here.