Ending Government Bailouts as We Know Them Stanford University, Dec. 10, 2009 Criteria and Elements for Evaluating Failure Resolution Plans Kenneth E. Scott Stanford Law School There are quite a few plans being proposed for better ways to resolve the failure of systemically important financial institutions (or SIFIs), in order that no longer may one be too big to fail and we can depart from an era of widespread bailouts at taxpayer expense. The goal is generally agreed on, perhaps because it is also generally poorly defined. The key concepts in the discussions are failure, systemic risk and bailout, and usually little attention is devoted to defining them. I want to attempt to identify the central elements of such plans, and to clarify the differences among which we must choose. My focus, therefore, is not on measures which hope to prevent failure, through regulation or operating requirements or better management, but on what is the best course to follow when they do not succeed. So I shall review what I think are the main questions raised by the conference papers, and then at the end some of the answers that seem to me to be indicated. I To begin with, what do we mean by the failure or insolvency of a financial institution? There are two concepts in common use: equity insolvency inability to meet obligations as they come due which is a liquidity standard, and economic insolvency assets are less than liabilities which is a balance sheet 1
standard. Banking law includes both: assets less than obligations, and inability to pay obligations in the normal course of business (12 USC 1821(c)(5)). For a nonbank financial institution to be forced into bankruptcy, however, there is only the liquidity standard of not paying obligations when due. If one wishes to minimize the amount of losses from a failure, is that the appropriate criterion? But to go to the economic standard, one immediately confronts all the valuation problems for the holdings of large and complex firms. The dilemma is posed by the controversy over fair value accounting; to the extent that the opponents of marking assets to market have their way, economic insolvency is further obscured. II What firms are we talking about? With Goldman Sachs and Morgan Stanley now bank holding companies, need we go beyond that category? (Of course, at some point they may attempt to exit from that status, and the proposals, hardly uncontroversial, by Paul Volker, George Shultz and Nicholas Brady among others, to separate banking from proprietary trading could lead to new large and complex firms.) If our concerns were limited to banks and bank holding companies, which ones? Different proposals refer to them as Tier 1 financial holding companies, large interconnected financial companies, and so on, but with definitions to follow. Should the definition be in the statute, or left to administrative discretion? Should they be designated in advance, with periodic updatings, or determined at the time of failure? Or should all financial institutions by covered in bankruptcy by a new Chapter 11F such as Tom Jackson advocates? Even if limited to bank holding companies, there is an issue over the scope of coverage. At present, failed banks are resolved by the FDIC, while holding companies and subsidiaries fall under chapter 11 of the Bankruptcy Code, and brokerages go into chapter 7 for liquidation or to the SIPC. Whatever the plan, should at least this fragmentation be ended? III 2
Who is in charge of the resolution process? At present, it is the FDIC for banks and a debtor-in-possession (or trustee) for most corporations. Should there be some form of consolidation here too? For example, could the FDIC continue to administer the assets/liabilities of failed banks, but under the overall supervision of a bankruptcy court when it is part of a larger organization? Or should the FDIC be given jurisdiction that extends beyond insured banks to cover all SIFIs, as William Kroener argues? Instead, should a new breed of special masters with expertise in large complex financial institutions be developed to administer SIFIs in bankruptcy? Related to this, who can commence a resolution proceeding? A banking supervisor or the FDIC can do so; if the Comptroller of the Currency, for example, determines that a national bank is insolvent (or merely in an unsafe or unsound condition to transact business), it may without notice or hearing appoint the FDIC as its receiver. For a non-bank institution, three creditors may file an involuntary petition which the court may grant (after a hearing if needed) and issue an order for relief. In the case of a SIFI, who should have this power? Should failure be determined by the exercise of regulatory agency discretion, or should private creditors also have authority to trigger a failure? Government agencies are subject to political pressure to forbear from forcing a closure, as banking history demonstrates only too clearly, while private parties have grounds to petition only when a financial institution is not paying its current bills. If the power is concurrent, either could be the first to move, a possibility to which Tom Jackson refers. IV Given a failure proceeding, how are losses to claimants to be determined? By administrative agency judgment, as in the power of a bank receiver to choose which assets and liabilities are to be assumed by a purchaser or transferred to a bridge bank (12 USC 1821(n)(1)(B))? Or by the outcome of market measures in a potentially more transparent judicial proceeding? This is a central element in the contrasting analyses of William Kroener and Tom Jackson. 3
The judicial process is likely to have certain advantages over an administrative process. The value of assets can be first determined in auctions or sales under Code 363 (assuming the sale is not rigged as it was in Chrysler). Failing that, there is provision for hearings on valuations. And the whole proceeding is open to the safeguard of judicial review. All of these consume time. The administrative process has the advantages of dedicated expertise and greater speed, as the 130 bank failures so far this year demonstrate. Part of that speed comes from the capacity of the Insurance Fund to take losses and issue guarantees upfront (but that has its moral hazard downside as well). And part of the speed comes from the absence of hearings and effective judicial review should that be viewed as a net plus or minus? The speed disadvantage of the judicial process might be lessened if the current proposals, which Richard Herring described in some detail, for willing wills (wind-down or failure plans) for financial institutions become reality, and especially if the result is simplification of the complex corporate structures of hundreds of subsidiaries and affiliates exemplified by Lehman that Kimberly Summe recounts. V Turning from process to more substantive matters, how are failure losses (however determined) to be allocated to various firm stakeholders (shareholders and creditors), or to taxpayers? No aspect of the current financial crisis has created more public anger than the use of public money to rescue failed firms by loans and capital assistance so that creditors would be bailed out. There seems to be a near-universal desire to devise an approach to failure resolution that does not depend on public funds, and that goal will be explored next. An insurance fund, such as FDIC administers for banks, can put some of the costs on covered firms (for example, pre-designated SIFIs), and (hopefully) not on taxpayers. The just-passed House bill (H.R. 4173) would create a $150 billion fund 4
for this purpose, by assessments on all financial institutions with >$50 billion in assets (most of which are unlikely to be of systemic importance). But a caveat is in order. The Government will always have the capability of bailing out favored claimants on an ad hoc basis, whether for reasons assertedly economic or actually political. The best that can be done is to try to design a resolution process that makes it somewhat less justifiable economically and less attractive politically. If such bailouts have to take the form of explicit budget expenditures that are highly visible and cannot be disguised as part of the resolution process (as appears currently the case with Fannie and Freddie), that might help. VI Do the loss allocations follow priority rules set and known in advance, or are they to some degree established ad hoc in individual cases? Put another way, to what extent is the private ordering of seniority and subordination of claims, voluntarily entered into, honored in the resolution process? Consistency and predictability are vital to efficient private finance and especially for troubled companies. In theory this is the major advantage of resolution and reorganization under the Bankruptcy Code, with a well-developed set of rules and long history of interpretation. The theory was tested, and found vulnerable, in the Chrysler chapter 11 reorganization, in part because judicial oversight in that case was defective or perfunctory. The essence of a bailout is the certain creditors are given more (or others less) than what their claims are entitled to under settled bankruptcy law. As noted, there will always be ways for the Government to prefer favored claims, but it should be the role of judiciary to force them to take place outside the bankruptcy proceeding and its structure of priority rules (Bankruptcy Code 1129) on which credit markets depend. VII Finally, and most importantly, are there any ways by which direct spillover costs can be reduced with minimal damage to the preceding considerations? 5
There are always losses to third parties from the failure of most any firm, large or small. But here we are concerned with a small subset of giant firms that occupy central positions in our system of financial intermediation and the flow of credit. The fear is that a failure or small set of failures might lead to the systemic risk of widespread collapse of the whole system. It would help greatly if we had a comprehensive and tested model of exactly how that might occur, but none exists. Work in developing one should have high priority. In its absence, there is plenty of talk about systemic risk and a paucity of clarity about its genesis, as John Taylor makes abundantly clear. The main suggestions from the conference, particularly by Kimberly Summe and William Kroener, are that we focus on the role and position of qualified financial contracts (QFCs) repos and derivatives in particular that are transacted daily in huge volume and key to the functioning of credit markets. The law, for both banks and other institutions, exempts them from some of the key provisions of the bankruptcy code, including the automatic stay and preference sections. The result is that the risks of counterparties to a failed institution are greatly reduced: they can terminate their contracts, net their positions, seize their collateral (if any and they are in the money) and sell it immediately. Does that reduce risks to the financial system as a whole, or increase them because counterparties have weaker incentives to monitor the information and police the exposures of firms whose survival is becoming more problematical? Would it better preserve value to transfer in bulk all of a given counterparty s positions to an acquirer, as was the prior rule for FDIC? Subjecting QFCs to standard bankruptcy rules would prevent abrupt termination and sales of collateral and the resulting market impacts, but it would increase the risk of declining collateral value which is the greater cost? Should such a change apply only to SIFIs? Those are fundamentally empirical questions, and ones to which we have no reliable answer. Perhaps we can, appropriately enough in this discussion, hedge our position. We could continue the exemption but only for QFCs with cash collateral: repos and some OTC derivatives. This would view the automatic 6
stay as intended mainly to protect the business from the forced sale by secured creditors of firm-specific assets, in order to preserve going-concern value in firms that can still achieve operating profits. Cash is not a firm-specific asset. VIII My own conclusions? I have identified a lot more questions than I have answers, and my answers can only be tentative. I think we are missing a lot of both the facts and theory necessary for any answer in which we can have much confidence. That of course is no impediment to Congressional action. So let me indicate, as I have intimated above, where I for one would be inclined to come out on these key elements. They can also provide a sort of checklist from which to construct the plan that you would favor. I think we should want both an equity and an economic standard for failure of a SIFI. Most of the time, as a practical matter, financial institutions are brought down by the flight of their short-term creditors, as we saw for Bear Stearns and Lehman. But ample liquidity can be used to prolong and deepen economic insolvency, the problem the Fed always faces in its discount window and other liquidity facilities. To the extent that we can get better current asset values, market discipline on the management of financial institutions is enhanced, to the benefit of both counterparties and taxpayers. Which firms are SIFIs, and who should be in charge of their resolution? At this time, they are all bank holding companies, and thus it might make sense to have them all designated and administered in failure by the FDIC on a consolidated basis. (There are of course other firms which play an essential service role in the financial system such as custodians or exchanges but I would put them in a different category.) However, that was not true in the past, and may not be in the future. It therefore makes sense to me that there also be a provision in the Bankruptcy Code for their reorganization, perhaps (to offer another option) with retention of FDIC for the insured bank part of the firm. That would permit proceedings to be instituted by either an agency determination or by private creditor filings concurrent jurisdiction. 7
I would regard the judicial procedure as much to be preferred over agency discretion in disposing of assets and determining losses, and in allocating those losses to claimants in a pre-determined and predictable order of priority. Bankruptcy courts should be charged with ensuring that any Government intervention to protect certain creditors is not achieved in the bankruptcy proceeding but outside it, openly and with appropriated funds. Finally, to reduce the likelihood of a systemic risk collapse of other institutions producing a Government bailout, I share Tom Jackson s position that the automatic stay exemption for QFCs (in either FDIC or judicial proceedings) should be retained only in the situations involving cash collateral most repos and many derivatives. Other derivatives should be subject to the usual bankruptcy constraints, which would cause counterparties to exert greater vigilance over the financial risk-taking of financial firms. Those at least are the implications I would draw from the informative presentations at this workshop, but I hope we can all take away a greater understanding of the issues on which we must come to grips. 8