Give bankruptcy a chance

Ms. Bair has a habit of ignoring the inconveniently obvious. To cite two other examples, when I asked her last year what her reaction was to those home owners who had bought a home within their means and diligently made their mortgage payments who were outraged by the unfairness of having to pay taxes to bailout their profligate defaulting neighbors, she replied in effect “tough.” She also did not react well to the suggestion that the pending bankruptcy of the FDIC last year was evidence that it had not fulfilled its legal mandate in the FDICIA to intervene banks before their capital drops to zero. The FDIC levied a special tax on insured banks to cover and/or avoid a shortfall in its resources as a result of large payouts to insured depositors in failed banks and this year its financial condition is better.

In the face of the failure of the FDIC to fulfill its legal mandate and of abuses afforded by administrative (FDIC type) resolutions in the case of the Chrysler and GM reorganizations/bailouts and others, the Shadow Financial Regulatory Committee has revised its earlier support for extending the administrative resolution tools of the FDIC to non bank financial institutions or at least to those that are systemically important. In its most recent policy statement on the “Resolution Regime for Troubled Financial Institutions” the committee said: “The Committee believes that the existing judicial corporate bankruptcy process is preferable to the current administrative process used to resolve failed banks, since it is more transparent, predictable and, most importantly, poses less risk to taxpayers. Therefore it should be extended to large complex financial institutions currently exempt from bankruptcy statues, with suitable modification to deal with the unique problems that financial institutions present. This structure should be the cornerstone of any new resolution process rather than adapting the current bank resolution process to financial institutions broadly defined. The primary objective of any revised bankruptcy process should be to pay claims among creditors in order of their legal priorities and not shift losses to taxpayers.” The Committee played a key role in the development of the FDICA two decades ago and its recommendations deserve serious consideration now.

Market discipline needs to be restored to risk taking by the financial sector. Predictable applications of bankruptcy procedures that replace taxpayer bailouts would make an important contribution to that objective. To be credible such procedures need to take into account the special nature of banks and other financial institutions and must be clearly specified in law.

Warren Coats retired from the International Monetary Fund in 2003, where he led technical assistance missions to central banks in more than 20 countries. He is Senior Monetary Policy Advisor to the Central Banks of Iraq and Afghanistan. His most recent book, One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina, was published in November 2007. He has a Ph.D. in economic from the University of Chicago and lives in Bethesda Maryland.