It is now almost three years since the Dodd-Frank Act was enacted to prevent the possibility that taxpayers would have to bail out "too-big-to-fail" banks. Yet there is serious concern that the legislation has not solved the problem. Many have called for new laws to limit the activities of very large banks or even, as in the bill recently introduced by Sens. Sherrod Brown and David Vitter, to cause them to break up. On Wednesday, the House Financial Services Oversight and Investigations Subcommittee held hearings on the continuing bailout issue, at which one of us (John Taylor) testified.
In our view, a straightforward reform of the bankruptcy code will facilitate the orderly bankruptcy of large failing financial institutions and thereby deal with the bailout problem. The reform should be enacted now, whether or not further actions are taken on big banks.
Under bankruptcy, a failing firm can either go into liquidation, in which it goes out of business and is dismantled into pieces that are sold off, or into reorganization. In reorganization, assets are assigned a market value, losses are recognized and then allocated among shareholders and then creditors in the order of priority stipulated by law. That often means stockholders are left with little or no ownership interest. Creditors, in order of contractual priority, have their debt claims written off, reduced in amount or converted into stock. In the end, the firm continues in business, often with new managers.
Title II of Dodd-Frank established a very different process, the Orderly Liquidation Authority. The Federal Deposit Insurance Corporation has the authority to "resolve" a large financial firm when it fails. Consistent with the original rallying cry for the legislation, it will "wipe out" shareholders. But the heart of the new resolution process is reorganization, and that is where the problem is.
The FDIC will transfer a selected part of the firm's assets and liabilities to a new "bridge" institution, with more discretion and less transparency and judicial oversight than in bankruptcy. Some creditors' claims can receive larger payments than under a typical bankruptcy—effectively a bailout—in the name of avoiding systemic consequences.
This violates the priority structure that underlies the entire credit market. It also reduces the risk incurred by large creditors expecting to be so favored, and thus the interest rate at which they are willing to lend the bank money. The big banks, able to borrow at a lower cost, are effectively getting a subsidy—$83 billion per year, according to widely-cited Bloomberg estimates based on an International Monetary Fund study.
The probability that some creditors will be bailed out has the perverse effect of increasing the likelihood of a bank's failure. Normally the risks a financial firm might choose to take are constrained by creditors as they monitor and protect themselves from losses by demanding collateral or cutting their exposure. Bailouts give them less reason for concern and action.
Shareholders in a failing bank "resolved" under Dodd-Frank won't be protected, but creditors said to be "systemically important" most likely will be. Who and when? That's up to political discretion. Hence there is uncertainty about how this process would operate, especially for complex international firms. Some believe that fearful policy makers would ignore it in the heat of a crisis, resorting to taxpayer bailouts as in the past. In short, too-big-to-fail and government bailouts remain possible or even likely.
There is a better way—and it involves adding a chapter to the federal bankruptcy code specifically for large financial institutions. A Chapter 14 would apply to all financial groups with assets over $100 billion. A specialized panel of judges and court-appointed special masters with financial expertise would oversee the proceeding, which would include all the parent's subsidiaries, including insurance and brokerage. (Under Dodd-Frank, insurance and brokerage services have to be handled separately—which adds complexity—while banks and other subsidiaries are under FDIC jurisdiction.)
A bankruptcy petition could be filed by creditors (as now) but also by the primary federal supervisor of the firm, or by a management that saw insolvency looming. The procedure to determine asset values, liabilities, sales of some lines of business, write-downs of claims, and recapitalization would take place according to the rule of law. There would be judicial hearings and creditor participation—neither of which are part of the Dodd-Frank resolution process. The strict priority rules of bankruptcy would govern (with some modifications for holders of repurchase agreements and swaps to limit their risks).
Chapter 14 would let a failing financial firm enter bankruptcy in a predictable, rules-based manner without causing disruptive spillovers in the economy. It would also permit people to continue to use the firm's financial services—just as people flew on American or United planes when those firms were in bankruptcy. The provisions also make it possible to create in bankruptcy a newly capitalized entity that would credibly provide most of the financial services the failed firm was providing before it got into trouble.
Customers would continue to do business with a financial firm after a Chapter 14 filing if they were confident the firm could meet its current obligations. That confidence would be achieved by giving post-petition creditors a high priority. In all likelihood, this priority would enable the firm to continue obtaining ample private financing—so-called debtor-in-possession financing—to provide liquidity for normal operations.
The managements of the five largest financial firms in the U.S. control the investment of over $8 trillion. A credible bankruptcy procedure designed specifically for these and other large financial firms would substantially reduce the occasions to use the Dodd-Frank resolution machinery and thus the concerns about its effects. It would make creditors' exposure much better defined and predictable, and thereby reduce the likelihood of bailouts and the perverse, unfair subsidy they create.
Mr. Scott is a professor of law and Mr. Taylor a professor of economics at Stanford. They are members of the Resolution Project at the Hoover Institution and co-editors of "Bankruptcy Not Bailout: A Special Chapter 14" (Hoover, 2012).