Too big to fail? No

Opinion: May 4, 2010 at 12:00a.m.

By David C. JOHN

Heritage Foundation

Driving the push in Washington for new financial regulations is a simple question: Is it possible for a large firm to fail without endangering the whole economy? The answer is yes. But how?

Imagine a process that allows a failing firm to wind down its financial affairs in an orderly way, without unnecessary collateral damage. That operates free of political pressures and special-interest lobbying. That’s handled by professionals who understand complex financial arrangements, not bureaucrats who dive for a dictionary when “derivatives” are mentioned.

Actually, it’s not hard to imagine at all. We’re not talking about a new exotic remedy. We’re talking about bankruptcy.

Which is not to say that no fixes are necessary. No, the bankruptcy that works so well today for almost all companies doesn’t apply to large financial institutions such as AIG, Citibank and Bank of America. There’s no system in place for their orderly restructuring.

Meltdown

That’s why, when the 2008 meltdown hit, the federal government ended up giving them hundreds of billions of tax dollars in capital infusions and loans.

Unfortunately, the main piece of legislation being debated in Washington, a bill sponsored by Sen. Christopher Dodd, D-Conn., won’t help matters. It would give power to wind down a failing firm to the Federal Deposit Insurance Corp. — as if dealing with a large financial institution in distress is like handling a small bank failure. It isn’t.

Indeed, the Dodd bill doesn’t take the most obvious step needed to prevent a recurrence: modernize bankruptcy laws to create an expedited way to restructure and close large financial firms.

Specifically, we need to add a chapter to the bankruptcy code to meet the special circumstances of “too big to fail” financial institutions.

Properly structured, this new chapter would allow large financial firms to close in an orderly way, reducing the potential for systemic risk. It wouldn’t give virtually unlimited powers to regulators who missed the first crisis.

The key changes to the bankruptcy statutes would be to give courts the ability to deal with a very different asset mix than is found in traditional companies. The court would need to be able to act very quickly to preserve asset value in the face of clauses in lending contracts that allow the lender to take immediate possession of firm assets upon a bankruptcy filing without going through a legal process to do so.

Flexibility

The court should be able to wind down the firm as quickly as possible to minimize the impact on the financial system. But it also should have the flexibility either to liquidate the firm totally or to restructure and sell it.

Handling this process through bankruptcy rather than with regulators has two additional advantages. First, the courts already have experience with large and complex bankruptcies. There would be no learning curve or grant of extraordinary new powers to a bureaucracy. Second and equally important, the courts will be impartial and free of the inevitable politicization that would accompany a government agency’s involvement in the process.

David C. John is senior research fellow in retirement security and financial institutions at The Heritage Foundation.