Livinglies's Weblog

At a time when news about Russia, health care, terrorist attacks and horrific fires dominates the headlines, it can be easy to forget that Congress continues to try to undo the regulatory reforms enacted in the wake of the 2008 financial crisis.

And the Trump administration, despite getting into office on a wave of populism, seems quite willing to embrace Congress’s rather conventional deregulatory agenda.

One core piece of the congressional drive to dismantle Dodd-Frank is the move to repeal orderly liquidation authority and with it the special powers of the Federal Deposit Insurance Corporation to deal with big bank insolvency. Instead, Congress would leave the failure of big financial institutions to the general bankruptcy system.

If one desires to return to the Gilded Age, with a financial crisis at least once every decade, this is a splendid plan.

A group of professors recently wrote Congress to alert it to the folly of repealing orderly liquidation authority and replacing it with bankruptcy. The professors’ letter is fine as far as it goes, but it does not go far enough.

The professors largely take Dodd-Frank at face value: When a big bank fails, we should try to use the bankruptcy courts first and resort to orderly liquidation authority only in extreme circumstances. That is fine in the abstract, but it bears thinking a bit more deeply about this issue.

Is it really plausible that any of the top half-dozen or so American financial institutions could resolve their financial distress in bankruptcy court? It could happen, just as I may travel to Mars some day.

More realistically, we have to worry that the hurdles to such a case, and the potential knock-on effects, are so significant that such a bank failure would and should proceed immediately to orderly liquidation authority.

That means that “bankruptcy for banks” should primarily focus on other creatures. For example, it might make sense to devise a bankruptcy court procedure for the next tier of banks and broker-dealers, should they fail. At present the failure of one of the larger “regional” bank groups might overwhelm both the F.D.I.C.’s traditional bank rescue tools and the bankruptcy code.

Seen in that light, it is at least as important that the bankruptcy code address a wide range of financial institutions as it stands ready to address the failure of the next Lehman Brothers.

This reveals the fundamental problem with Congress’s present approach. Not only would it leave regulators with no tools to address the failure of a big financial institution, but it would replace that approach with a form of bankruptcy that would be entirely useless for those financial institutions that might actually use a bankruptcy filing.

In particular, Congress’s proposed bankruptcy process for banks tries to move the “single point of entry” strategy developed for the big banks in orderly liquidation authority to the bankruptcy court. Under this strategy, a bank is recused by forcibly converting junior debt to equity.

All the big American banks are revamping their capital structure to facilitate single point of entry. The medium-size financial institutions are not.

So Congress proposes to kill off orderly liquidation authority, the tool that would be of most use to the really big banks, and replace it with a bankruptcy system that will be irrelevant for the really big banks and won’t work for medium-size banks.

As a result, we will bail out both in the next financial crisis.

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