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Thursday, May 5, 2011

How to Avoid the New Bailout Authority

Title II of the Dodd-Frank bill, which creates a new orderly liquidation authority for financial institutions, has recently come under fierce attacks from a variety of perspectives. Paul Ryan writing in the Wall Street Journal on April 5 argues that we should get “rid of the permanent Wall Street bailout authority that Congress created last year.” Then, after reading an FDIC report on how Title II would have worked in the case of Lehman, Simon Johnson in effect agrees with Ryan arguing that any Treasury Secretary, at least one in the Paulson-Geithner mold, would go right around Title II and simply bail out the creditors of large financial firms as in 2008. Recently Stephen Lubben has piled on in The FDIC’s Lehman Fantasy and Michael Krimminger (FDIC General Council) finally replied.

Missing from the recent debate is the role of a possible amendment to the bankruptcy code to deal with large financial firms. An amendment could supplement—or even replace—the orderly liquidation authority of Dodd–Frank and deal with the problems raised by Paul Ryan and Simon Johnson. One such amendment has been proposed by a group of lawyers, economists and financial institution experts sponsored by Stanford University’s Hoover Institution. The amendment is called “Chapter 14,” because this is currently an unused chapter number in the U.S. Code on Bankruptcy. Last week we (I'm a member of the group) presented the idea to Michael Krimminger at the FDIC and to the legal staff at the Fed which is responsible for a mandated study of the bankruptcy code. The idea is explained here.

In brief, the problems with the new orderly liquidation authority, at least in the absence of a new bankruptcy process, is that it increases uncertainty, raises constitutional due process issues, increases the probability of bailouts, and creates moral hazard. Chapter 14 would give the government a viable alternative to Title II and thereby avoid these problems. We argue that government officials would likely find Chapter 14 more attractive than Title II, or a more direct bailout, and thereby choose this option. So with such an alternative, bailouts would be less likely. As George P. Shultz puts it, "Let's write Chapter 14 into the law so that we have a credible alternative to bailouts in practice." Compared with Title II, Chapter 14 would more predictable and rules-based and it would minimize spillovers to the economy. It would also permit people to continue to use the company’s financial services—just as people continue to fly when an airline company is in bankruptcy.

Chapter 14 would differ from current bankruptcy law in Chapter 7 and Chapter 11. It would create a group of “special masters” knowledgeable about financial markets and institutions; a common perception is that bankruptcy is too slow to deal with systemic risk situations in large complex institutions, but under the proposal there would be capacity to proceed immediately. In addition to the typical bankruptcy commencement by creditors, an involuntary proceeding could be initiated by a government regulatory agency, and the government could propose a reorganization plan—not simply a liquidation. An advantage of this approach is that debtors and creditors negotiate with clear rules and judicial review throughout the process. In contrast, the orderly liquidation authority is less transparent with more discretion by government officials and few opportunities for review.