The Value of Insolvency Safe Harbors

By Philipp Paech (London School of Economics)

“Safe harbor” privileges in insolvency are typically afforded to financial institutions. They are remotely comparable to security interests as they provide a financial institution with a considerably better position as compared to other creditors should one of its counterparties fail or become insolvent. Safe harbors have been and continue to be introduced widely in financial markets. The common rationale for such safe harbors is that the protection they offer against the fallout from the counterparty’s insolvency contributes to systemic stability, as the dreaded “domino effect” of insolvencies is not triggered from the outset. However, safe harbors also come in for criticism, being accused of accelerating contagion in the financial market in times of crisis and making the market riskier. In this article, I submit that the more important argument for the existence of safe harbors is liquidity in the financial market. Safe harbor rules do away with a number of legal concepts, notably those attached to traditional security, and thereby allow for exponentially increased market liquidity. Normative decisions by legislators sanction safe harbors, as modern markets could not exist without these high levels of liquidity. To the extent that safe harbors accelerate contagion in terms of crisis, which in principle is a valid argument, specific regulation is well suited to correct this situation, whereas to repeal or significantly restrict the safe harbors would be counterproductive.

The full article may be found here.

For previous Roundtable posts on the safe harbors, see Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“; Janger & Pottow, “Implementing Symmetric Treatment of Financial Contracts in Bankruptcy and Bank Resolution“; and Lubben, “Lehman’s Derivatives Portfolio.”