Jeffrey Lacker, President of the Richmond Federal Reserve Bank, made the case for why large financial institutions should subject to bankruptcy as the ABI Luncheon Keynote Speaker. He started his address with the question "Why is a central banker interested in bankruptcy?" His answer was that during the financial crisis of 2007-2008, the government played a role by distorting incentives of market players with multiple discretionary interventions which destabilized expectations. He called on the government to realign incentives of major market participants by using bankruptcy instead of discretionary government interventions. The full text of his speech is available here.
Mr. Lacker said that the advantages of the bankruptcy system are that it is a collective proceeding, it is subject to judicial supervision and is a predictable, rules-based system. He described the bankruptcy process as "one of the best tools we have for reconciling the goals of creditors and debtors." He said that the probability of bankruptcy versus the benefits of risk taking would change the incentives of large banks.
He gave some historical background for the problem. When the Fed was founded 100 years ago, state law prevented branch banking. As a result, there were 27,000 banks in the country. This meant that banks could not pool capital between locations. In 1933, the government adopted government funded deposit insurance primarily to protect small rural banks.
Fast forward to the present era (my words, not his) and the government began intervening to protect the uninsured creditors of banks through assisted mergers (such as Bear Stearns) and lending on favorable terms. These actions dampened incentives to tamp down risk. As financial firms grew to greater size, there was a vicious circle as the government felt compelled to handle financial failure outside of bankruptcy which encouraged more risk taking. In 1999, only 45% of the creditors of financial firms had explicit or implicit government guaranties. By 2012, this had risen to 57%.
In 2007, there were two mutually reinforcing conditions present which led to problems. Investors felt protected and the government felt compelled to confirm expectations. They feared a domino effect where if they did not support firm A, investors would pull away from firm B.
According to Mr. Lacker, the government's inconsistent actions exacerbated the problem. The government arranged for the merger of Bear Stearns with JP Morgan, then it allowed Lehman Brothers to file bankruptcy, then it provided an emergency loan to rescue AIG. As a result, he said that the expectations that created the problem remained alive and well.
Dodd-Frank was intended to remedy the problem. He said that beefing up ex ante measures is good but it doesn't solve the problem once institutions are in trouble. He said that it is asking too much for bank examiners to function as the frontline actors to prevent risky behavior.
Dodd-Frank also created the Orderly Liquidation Authority for large financial institutions. Mr. Lacker said that while this borrows many features from bankruptcy, it retains many flaws. The OLA allows some creditors to receive more than they would in bankruptcy. The availability of funds injected from the treasury is like debtor-in-possession financing but without being tested by the market. The OLA does not have the checks and balances of bankruptcy. This system dampens creditors' incentives to monitor risk taking, he said. If the FDIC is anticipated or assumed to provide assistance, it will likely provide it.
He also discussed the single point of entry feature of Dodd-Frank. Under this provision, the government can take control of the top level holding company which the subsidiaries remain open. The regulators create a bridge company to transfer the assets of the holding company to which will eventually be turned over to the private sector. The expectation is that the shareholders of the holding company will be wiped out while the creditors of the holding company receive the equity in the new entity. He described this as a "bail-in" rather than a bail-out.
Mr. Lacker said that the resolution plans required under section 165 of Dodd-Frank were a positive feature. The goal is to have companies wound down under the Bankruptcy Code without government support. This contrasts with past practice where there was little or no advance planning for insolvency of large financial institutions. He stated that the recent dependence on short terms lending arose from regulators' aversion to bankruptcy, which this provision moves away from. As a result of this planning or "living wills" for large financial institutions, they can be required to obtain more capital, restrict risk taking or divest assets.
Lacker said that eleven banks have gone through this process but there is substantial work left to be done. Other reforms to be addressed are requiring a "rational and less complicated legal structure," creating severability by making institutions self-contained in each country and keeping them from being dependent on inter-company lending. However, he said that a continued problem is the excessive reliance on short term borrowing which would mandate substantial debtor-in-possession financing from the government in order to maintain operations.
Mr. Lacker said that the Bankruptcy Code could be adapted to deal with large financial firms. He said that bankruptcy could be used to concentrate losses in the parent company. A problem that he pointed out is that derivatives are excluded from the automatic stay and other bankruptcy provisions which encourages risk and a shadow banking system.
Lacker stated that "if we do hard work" to make plans now, there will be a healthy realignment of expectations and incentives. He said that this will not be complete until we allow a large financial entity to file for bankruptcy. He said that the goal was that once we have robust provisions in place, we can eliminate the power to make ad hoc rescues. He said that bankruptcy is advantageous for financial firms because it provides a common pool and consistent outcomes.
In closing, Mr. Lacker stated that expectations led to the financial crisis. He said that the bailout friendly, too big to fail system is unstable and unfair.