Give bankruptcy a chance

Warren Coats Contributor
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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.

Large losses to depositors and the economy from the failure of 9,093 banks from 1930 to early 1933 led to the creation of the FDIC and deposit insurance to limit panic deposit withdrawals (runs) from insolvent banks or banks rumored to be insolvent. However, even the more flexible tools given to the FDIC to resolve failing banks were used reluctantly and generally too late (i.e. after a bank’s economic capital was already negative). Regulators ignored the probable insolvency of many banks (forbearance) in the generally futile hope that their condition would improve. Thus the banking and Savings and Loan crisis of the 1980 through mid 1990s saw an additional 2,912 financial institutions fail only after they were deeply insolvent at a cost of $150 billion to taxpayers.

In an effort to overcome the propensity of regulators to delay taking action, and the cost of such delays, congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991, which mandated the resolution of banks that became “critically undercapitalized” (below 2 percent of assets) and provided a mandatory escalation of structured remedial measures as a bank’s condition deteriorated toward insolvency. For over a decade FDICIA restored strong market discipline of bank behavior. Virtually no banks failed during that period because they took the measures needed to remain well capitalized and avoid excessive risks in order to avoid the FDIC’s intervention.

More recently this sterling performance has deteriorated. Not only have regulators (OCC, Fed, FDIC, etc.) failed to collect and analyze data that would be relevant for assessing and monitoring the potential systemic risks of various financial instruments and practices and responded to failures inconsistently, they have intervened later in the process. As a result the cost to the FDIC of its interventions, which should be zero if undertaken as soon as a bank is critically undercapitalized, has increased. The FDIC suffered larger losses in its recent resolutions than was normally case in the 1990. The “Prompt Corrective Action and Structured Early Intervention and Resolution” requirements of the FDIC Improvement Act of 1991 (FDICIA) have apparently not been as rigorously adhered to as they were earlier.[2]

While the Federal Reserve’s response to the liquidity aspects of the financial crises were bold, appropriate, and stabilizing, the government’s (both Bush’s and Obama’s) handling of financial sector insolvency has been confused and unpredictable. The Troubled Asset Relief Program (TARP) tops the list of ill-conceived interventions. The government cannot seem to figure out whether it needs to throw measures to strengthen the system in the long run out the window in order to “save” it in the short run. It is still not sending a clear message to the market about what the rules of the game will be going forward. Without clarity on the rules of the game it is difficult, verging on reckless, for investors to take the plunge to get the economy going again.

Consider recent statements by Sheila Bair, Chairman of the FDIC. Quite properly lenders have reacted to the unexpectedly high default rates of their loans by strengthening their loan underwriting standards. In reporting a 7.5 percent decline in bank lending in 2009, “Bair said that the vast majority of the lending decline was the result of cutbacks by the nation’s largest banks, which have tightened qualification standards for borrowers and increased the proportion of money that they hold in reserve against unexpected losses.

‘Large banks do need to do a better job of stepping up to the plate here,’ Bair said.”[3] We can only wonder which direction the government is pushing for (safety or more credit regardless).

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.