The Treasury Department is expected to release a much-anticipated report this fall reviewing post-crisis regulatory authorities for dealing with major financial institutions nearing failure during a financial crisis. This review is expected to consider ways to modify the Bankruptcy Code and whether to eliminate the Dodd-Frank Act’s resolution authorities.
Treasury would be wise to recommend strengthening the Bankruptcy Code while clarifying, but not eliminating, these Dodd-Frank authorities. This would confirm that the Bankruptcy Code is the primary process for resolving a failed firm, which Dodd-Frank intended, but also preserve crucial resolution authority as an emergency backstop.
In response, the Dodd-Frank Act established a procedure for resolving large financial firms, called the orderly liquidation authority (OLA), to let financial institutions fail outside of the traditional bankruptcy process to make bailouts less tempting for policymakers. The financial crisis highlighted the problem of too-big-to-fail financial institutions. The potential collateral damage to the financial system and economy from the disorderly failure of such firms motivated policymakers to provide temporary financial support to individual institutions and specific categories of financial firms. Although the government came out ahead on most of these emergency loans, the public had no appetite to be put on the hook for any future bailouts of financial firms.
Despite this new authority, Congress was clear in Dodd-Frank that bankruptcy should be the preferred method for dealing with failures. Regulators have since taken steps such as mandating greater loss absorbing capacity at financial firms and living will plans that envision a quick transfer of assets to debt-free entities. Those steps were intended to help address substantial crisis-era problems such as the risk of bank runs and fire sales in bankruptcy during a contagious panic.
However, a bankrupt firm still needs credit to maintain its operations during bankruptcy proceedings so that the financial system and the firm’s customers are minimally impacted by its failure. Credit is generally scarce during a financial crisis, making it difficult for financial firms to operate through bankruptcy proceedings. That in turn makes a disorderly liquidation or bailout more likely without a reliable source of liquidity in place.
OLA gives Treasury the authority to provide this emergency liquidity, while putting in place proper safeguards to protect taxpayers. For instance, this authority may only be used to provide temporary liquidity and may not be used to provide capital to insolvent firms. Any liquidity provided must be repaid by surviving firms rather than by asking taxpayers to foot the bill. This emergency liquidity authority along with its safeguards should be kept.
No fix to the Bankruptcy Code will be perfect nor can every contingency be addressed.
Instead of repealing OLA, the Treasury review should focus on bankruptcy reform that meets the special needs of financial firms, this will make the use of OLA less likely. The Bankruptcy Code can be improved by incorporating the strategy the FDIC has laid out for resolving failing financial institutions. This strategy would move healthy assets from a failed financial firm to a bridge holding company that can continue operations and minimize disruption to customers, while ensuring shareholders and long-term creditors in the failed firm take losses instead of taxpayers.
The Treasury review should also recommend that Congress ensure OLA is used as a last resort by clarifying the parameters of when it should be invoked to minimize taxpayer exposure. For instance, Congress should require OLA financing to be fully secured and only provided to solvent and recapitalized firms at above-market rates.
The ideal solution for the too-big-to-fail problem is to allow firms to fail in an orderly manner through an improved Bankruptcy Code. However, no fix to the Bankruptcy Code will be perfect nor can every contingency be addressed. Uncertainty will remain over whether private financing for the bankruptcy of a large financial firm will be available in a timely manner during a future crisis. For those reasons, Congress should change the Bankruptcy Code but keep OLA as an emergency “break the glass” backstop to protect taxpayers and the economy.