Senator Reed Introduces Study Bill to Assess Systemic Risk Impact of “Bankruptcy-for-Banks” Reforms

On December 6, Senator Jack Reed introduced a bill aimed at establishing a more informed basis for regulatory and policymaking action on financial institution bankruptcies. The bill would mandate bi-annual reports by financial regulators on key issues in the resolution of financial companies under the Bankruptcy Code, such as potential reforms to the safe harbors for repos and derivatives, strategies for mitigating the systemic impact of financial company bankruptcies, risks embedded in the “single point of entry” strategy (particularly if it is tried and fails), and sources of liquidity for a financial company in bankruptcy. Overall, the bill calls for regulators to make a big picture assessment of how various bankruptcy reforms would affect systemic risk, drawing attention to weaknesses in some of the policy proposals in this area.

The bill also would also amend bankruptcy court procedure for financial firm bankruptcies. Most notably, it would revise the Bankruptcy Code to give the Federal Reserve and other regulators standing to be heard in financial company bankruptcies. Additionally, the bill would provide for the Federal Reserve and the FDIC, jointly, to propose five potential trustees for the financial company, with the United States trustee selecting the final appointee from this list. Finally, the bill would require the Supreme Court to issue a rule establishing a procedure for appointing a bankruptcy or district court judge with appropriate expertise to preside over the bankruptcy resolution of a financial company.

The Roundtable’s full update on the bill is available here.

(This post was authored by Rebecca Green, J.D. ’17.)


Related posts on legislative reform proposals are available here and here. The Roundtable has also posted previously on policy issues surrounding “bankruptcy for banks” reforms. For example, see Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“; Roe & Adams, “Restructuring Failed Financial Firms in Bankruptcy“; and Lubben & Wilmarth, “Too Big and Unable to Fail.”

Too Big and Unable to Fail

By Stephen J. Lubben (Seton Hall University School of Law) and Arthur E. Wilmarth, Jr. (George Washington University Law School)

Financial regulation after the Dodd-Frank Act has produced a host of new regulatory tools for resolving failures of systemically important financial institutions (SIFIs). The explicit goal of this new “resolution” regime is to enable SIFIs to go bankrupt without a government bailout, just like other businesses. In our paper, forthcoming in the Florida Law Review, however, we express significant doubts about the new regime’s ability to work as advertised.

The “single point of entry” (SPOE) strategy, which focuses all resolution efforts on a SIFI’s parent holding company, addresses a very stylized, even hypothetical sort of failure. We believe that it is unlikely to work during a global crisis that involves multiple failing SIFIs operating thousands of subsidiaries across dozens of national boundaries.

The Federal Reserve’s “total loss absorbing capacity” (TLAC) proposal is closely tied to SPOE. It would require SIFI holding companies to issue large amounts of debt securities that can be “bailed in” (converted into equity) in a resolution proceeding to make the holding company solvent again. In our view, TLAC debt will also create a new, more opaque way to impose the costs of SIFIs’ financial distress on ordinary citizens, because retail investors in brokerage accounts, mutual funds, and pension funds are likely to be the largest TLAC debtholders.

We propose several strategies for forcing SIFIs and their Wall Street creditors to internalize at least some of the costs of the enormous risks they create. Among other things, mutual funds and pension funds that invest in TLAC debt should disclose the bail-in risks to investors and should include in their offering materials “black box” warnings similar to those already used in selling junk bonds to investors. In addition, each SIFI should describe its resolution plan on a web page that also contains a straightforward discussion of the risks TLAC debtholders are taking on—risks that creditors and counterparties of operating subsidiaries are unwilling to assume. Only with such disclosures can the hazards of TLAC debt be appropriately priced by the market.

The full paper can be found here.

 

Developing a New Resolution Regime for Failed Systemically Important Financial Institutions

Stephanie Massman, J.D. 2015, Harvard Law School

 

In the wake of the 2007-2008 financial crisis, criticism surrounded not only the government bailouts, but also the decision to not bail out Lehman Brothers, which led to its lengthy and value-destructive chapter 11 bankruptcy. In response to this criticism, Congress enacted the Orderly Liquidation Authority (“OLA”), a regulatory alternative to bankruptcy for systemically important financial institutions (“SIFIs”), included as Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The OLA, although perceived to be a radical departure from traditional bankruptcy, incorporates many familiar resolution principles. The most significant departures from the Bankruptcy Code are those designed to ensure financial stability in the national and global economies in the event of a SIFI failure; because the Bankruptcy Code does not currently specifically provide for a SIFI failure, it does not address financial stability concerns at all. Furthermore, by banning future government bailouts and imposing new stays on qualified financial contracts, the OLA also seeks to correct skewed market discipline incentives surrounding SIFIs—including those arising due to the “Too Big To Fail” subsidy—which may have caused the “moral hazard” problems that were a contributing factor in the financial crisis. Unfortunately, the prescribed tactics for accomplishing a resolution under the OLA may in fact implicate new moral hazard concerns, which have yet to be addressed by regulators. What further remains to be seen is both the extent to which the regulatory agencies will assume their new statutorily ordained authority to regulate these SIFIs and the extent to which the market will find their regulations credible.

This article examines the current state of development of a resolution process for SIFIs under the OLA and evaluates how effective the OLA is likely to be in preserving financial stability and minimizing moral hazard.

To view the full article, click here.

The Chapter 14 Proposal in the Senate

Author: Stephen D. Adams*

[This week the Roundtable looks at the Chapter 14 proposal in the Senate.  This post provides an overview of Chapter 14 as background to Bruce Grohsgal’s thoughtful piece from the ABI Journal available here.]

The Taxpayer Protection and Responsible Resolution Act of 2014 (S. 1861), commonly known as “Chapter 14”, aims to “end ‘too big to fail’ by repealing Dodd-Frank’s Title II” and “replacing it with a bankruptcy process” capable of safely resolving a Systemically Important Financial Institution.

The Chapter 14 proposal envisions a number of changes to the bankruptcy process, grouped into a new bankruptcy chapter (hence “Chapter 14”, a previously unused chapter) that would be available to bank holding companies. Chapter 14 would be run by a special group of financially experienced district judges, could allow for the FDIC to be appointed as trustee, and would have no period of plan exclusivity. In order to effect a quick sale similar to the FDIC’s single point of entry strategy for Title II, the Senate bill would add a two-day stay to bankruptcy’s swap safe harbors to give the trustee a chance to transfer the entire swap portfolio to a new company that is solvent. Repos, however, are treated like secured debt, but with the ability to immediately sell off high quality collateral (though not non-agency Mortgage-Backed Securities).

The Senate Bill draws on work from the Hoover Institution’s Resolution Project that proposed the original Chapter 14 in 2009 and 2010 and updated it recently.

Documents related to the original Chapter 14 proposal work, including proponents’ descriptions of the case for a new Chapter 14, can be found here. The text of S. 1861 can be found here. Professor Thomas Jackson’s Congressional testimony about Chapter 14 in 2014 can be found here.

*Editor, Harvard Law School Bankruptcy Roundtable, and Research Director, Harvard Law School Bankruptcy and Corporate Restructuring Project.