Pushing Back on Claim Bankruptcy Can’t Handle Big Bank Failure

This week, Mike Konczal wrote a post criticizing the GOP’s position on financial services reform. While I have no love for the Republican party, he did say something pretty misleading that I want to push back on.

Simon Johnson says: “This proposal is dangerous, irresponsible, and makes no sense. The bankruptcy process simply cannot handle the failure of large complex global financial institutions — without causing the kind of worldwide panic that followed the collapse of Lehman and the rescue/resolution of AIG.” And he’s right.

In fact, let’s go to the bankruptcy judge in charge of the Lehman case (my bold):

“I have to approve this transaction [Barclays offer] because it is the only available transaction. Lehman Brothers became a victim, in effect the only true icon to fall in a tsunami that has befallen the credit markets. This is the most momentous bankruptcy hearing I’ve ever sat through. It can never be deemed precedent for future cases. It’s hard for me to imagine a similar emergency.”

And Lehman wasn’t even that big of a firm. Could you even imagine bankruptcy the next time through? If the bankruptcy judge himself is saying that this is a disaster and can never be repeated, why would you want to repeat it?

Okay, this statement came from the bankruptcy judge in the days right after the Lehman collapse. To read the quote out of context, you’d think that the judge may have said this at a hearing in the past week, 18 months after the fact. Why does it matter? Because there is a difference between saying the bankruptcy process can’t handle a big failure in a few weeks, and the bankruptcy process can’t handle a big failure over a two year period of time.

To begin with, I agree that the current bankruptcy system is not ideal for winding down LCFIs. But we can change the system to speed up certain parts of the proceeding, and be able to deal with failures with greater ease. Furthermore, if lenders realize that their money at an institution may be tied up for a while if they lend it then interbank lending, including overnight lending, will be much more prudent. And in any case, it wasn’t the fear of counterparty risk getting jammed up in the system that caused the markets to freak out. It was the unpredictability of regulators that was a key in what caused the liquidity shortage.

Anyway, getting back to the point: a major bankruptcy like if A.I.G. would certainly take a while to figure out. But just because the Lehman judge one day in said the bankruptcy shouldn’t be precedent doesn’t mean living in a world of perpetual bailouts is ideal. Why not use bankruptcy? Because counterparties wouldn’t get their short-term agreements met for some time. And that is not a good reason because it is essentially getting rid of a necessary incentive for firms to have due diligence in what they lend.

Some more thoughts on bankruptcy here. Also see this policy study from last year looking at the House financial services reform bill.