Empowering Financial Bankruptcy

The derivatives market is exempt from rules that stop creditors from grabbing collateral and terminating their contracts when the debtor files for bankruptcy. They are also exempt from rules that impede better-informed creditors from seizing assets and running off just before a bankruptcy, even if their positions are needed, say, to sell a portfolio intact to another business, and even if the fleeing creditor would eventually be paid in full, with interest.

Regulators’ push for sounder finance has so far focused on requiring more capital, creating safer products, and establishing more resilient business structures. These are indeed the right priorities. But the US Congress and regulators have said all along that bankruptcy is the preferred way to restructure failed financial firms. If a judicial bankruptcy process could work, the thinking goes, it would minimize the likelihood of taxpayer-financed bailouts and disruption of financial markets and the real economy.

The problem is that bankruptcy today is no more capable of restructuring a failed financial firm than it was in 2009; a failed Lehman in 2014 would be no less disruptive to the world economy. US regulators, for example, cannot first try bankruptcy before deploying their expanded powers under the ; if they did, the bankrupt firm’s counterparties in the derivatives and repo markets would close out their contracts and dump their collateral as soon as they could.

Once that happened – probably within hours of the bankruptcy filing – the firm would be beyond repair. Regulators could not go back and fix it with their new Dodd-Frank powers, because the firm would already be ripped asunder. So, as it stands now, regulators need to preempt bankruptcy, not rely on it, because as soon as any failed financial firm files for bankruptcy, it has signed its own death warrant.

The regulators’ letter to the ISDA asked the derivatives industry to rewrite its standard contracts, so that a bankrupt firm’s portfolio is not ripped apart as soon as it files. This is a big step in the right direction. But, as regulators reflect further, they will recognize that they cannot rely on the derivatives industry to revise its contracts any more than industrial bankruptcy relies on creditors’ contracts to stop failed firms from being ripped apart. Many simply will not use the contract terms.

Perhaps regulators will find that they must require that the regulated have the desired contract provisions. That solution will be incomplete, however, because not all derivatives traders are regulated financial institutions, and because many creditors would find ways to circumvent the contract and the requirement. If the coverage is not complete, one can expect the regulated to complain that they have been placed at a competitive disadvantage.

Regulators may well need to turn to bankruptcy laws to fix the problem. The regulators’ call to the ISDA for voluntary action will not amount to much if it is just a request to the derivatives industry to act against its own financial interests. But it does start the regulators down the road to more serious reform.

Mark Roe is a professor at Harvard Law School.

Copyright: Project Syndicate, 2014.