North Carolina Law Review

University of North Carolina School of Law

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Bankruptcy's Lorelei: The Dangerous Allure of Financial Institution Bankruptcy

February 5, 2019

97 N.C. L. Rev. 243 (2019)

 

The idea of a bankruptcy procedure for large, systemically important financial institutions exercises an irresistible draw for some policymakers and academics. Financial institution bankruptcy promises to be a transparent, law-based process in which resolution of failed financial institutions is navigated in the courts. Financial institution bankruptcy presents itself as the antithesis of an arbitrary and discretionary bailout regime. It promises to eliminate the moral hazard of “too big to fail” by ensuring that creditors will incur losses rather than being bailed out. Financial institution bankruptcy holds out the possibility of market discipline instead of an extensive bureaucratic regulatory system.

 

This Article argues that financial institution bankruptcy is a dangerous siren song that lures with false promises. Instead of instilling market discipline and avoiding the favoritism of bailouts, financial institution bankruptcy would likely simply result in bailouts in bankruptcy garb. It would encourage bank deregulation without the elimination of the moral hazard that produces financial crises. In particular, it would undermine the federal regulators’ single most powerful tool for managing systemic risk, the living wills power, even while imposing a resolution process that is doomed to failure.

 

A successful bankruptcy is not possible for a large financial institution absent massive financing for operations while in bankruptcy, and that financing can only reliably be obtained on short notice and in distressed credit markets from one source: the U.S. government. Government financing of a bankruptcy would inevitably come with strings attached, including favorable treatment for certain creditor groups. This would result in bankruptcies that resemble those of Chrysler and General Motors, which are much decried by proponents of financial institution bankruptcy as having been disguised bailouts.The central flaw with the idea of financial institution bankruptcy is that it fails to address the political nature of systemic risk. What makes a financial crisis systemically important is whether its social costs are politically acceptable. When they are not, bailouts will occur in some form because crisis containment inevitably trumps rule of law. Resolution of systemic risk is a political question, and its weight would warp the judicial process. Financial institution bankruptcy will merely produce bailouts in the guise of bankruptcy while undermining judicial legitimacy and the rule of law.

 

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