Give bankruptcy a chance

We have just experienced the consequences of excessive risk taking by financial enterprises, real estate speculators, and overstretched homeowners fueled by the expectation that taxpayers would cover their losses if risky bets failed. Washington’s response to the financial crisis has confirmed these expectations and is thus compounding the problem for the future. Recovery of the U.S. economy and of the financial sector that finances it requires stabilizing the rules of the game and restoring market discipline of risk taking. Washington must give up the conceit that it can reliably micromanage socially desirable outcomes successfully. Regulatory rules must return the cost and reward of risk taking from the taxpayer to the risk taker. The moral hazard of financial risk takers taking the profits and tax payers bailing them out when their bets fail has seriously corrupted our financial system. It will not be easy to put that genie back in the bottle, but it can be done.

Government policies that have bailed out failing banks and other financial enterprises have seriously distorted the incentives faced by these firms leading to far too much leverage and risk taking (heads I win, tails you lose) in the financial sector. Profits from such behavior are huge most of the time and the government picked up the losses most of the time. When the government financially assisted the sale of Bear Stearns to JP Morgan Chase in March 2008 the market’s assumption that the government would stand behind (bailout) financial institutions whose housing and other credits had gone bad were confirmed. When the government let Lehman Brothers fail in September 2008 (after many investors had loaded up on its products after the Bear Stearns bailout) markets were confused and went into shock.

The government’s position (largely the Treasury and the New York Federal Reserve) was that it lacked the efficient resolution tools available for commercial banks through the Federal Deposit Insurance Corporation (FDIC) for the Bear Stearns (an investment bank) of the world. No one really knew, for example, what the knock-on effects of a failure of an insurer of trillions of dollars in bank credits (AIG) would be, and after the Lehman Brothers experience the government was not willing to risk finding out the hard way. In fact, the regulators had fallen behind in collecting and analysis financial data on financial instruments and practices that would have helped them answer that question. Plans to do so in the future are reassuring as is the intention to better plan for the resolution of complex financial firms should they fail (“living wills”).

In order to make the replacement of bailouts with resolution (sale in whole or in part, liquidation, etc) a practical option, both the Bush and Obama administrations have asked Congress to extend the administrative resolution tools of the FDIC for banks to systemically important non bank financial institutions. Failing or failed bank resolution is administer by the FDIC in place of judicially monitored reorganization or liquidation applied to non-bank companies. Traditional judicial bankruptcy procedures for insolvent corporations were rarely applied to banks around the world for fear that tying up depositor funds pending the liquidation of assets over periods of years would be too disruptive to the financial system. Banks were almost universally bailed out instead. America’s administrative resolution of banks made the process more efficient and thus easier and less disruptive to use. Potential abuse of the FDIC’s broad administrative resolution powers is limited by the requirement that it adhere to the least cost approach (to the insurance fund and ultimately to taxpayers) to resolution.