Academic journal article Economic Perspectives

A Comparison of U.S. Corporate and Bank Insolvency Resolution

Academic journal article Economic Perspectives

A Comparison of U.S. Corporate and Bank Insolvency Resolution

Article excerpt

Introduction and summary

Finns may become financially insolvent. When they do, legal processes are required to efficiently and equitably resolve the claims of creditors and other stakeholders. In the U.S., unlike most other countries, two distinct legal processes exist for resolving the failures or bankruptcy of commercial banks and most other corporations. (1) Underlying these two regimes are different assumptions, goals, and strategies for resolution. In contrast, in most countries, resolution of bank insolvencies is guided by the general corporate bankruptcy code, although in some of these countries special provisions for banks are carved out. (2)

Bank insolvencies are resolved differently primarily because banks provide a vital service in, among other things, issuing liquid deposits, which tend to serve as money, extending credit, and processing payments. It is believed that any interruption in these activities with resulting losses would have a more serious adverse impact on the economy of the insolvent bank's market area than any interruption in the operation of other insolvent firms. In order to reduce the possible adverse effects of bank insolvency resolution in the U.S., the special code for banks, which is contained in the Federal Deposit Insurance Act (FDI Act), differs significantly from the general federal corporate bankruptcy code in a number of ways enumerated in table 1. (3)

In particular, the general corporate bankruptcy code in the U.S. tends to favor debtors over creditors and, especially for large insolvent firms, in-place managers and attempted rehabilitation (Chapter 11) rather than liquidation (Chapter 7). In contrast, the bank insolvency code favors depositors (usually the major class of bank creditors) over debtors, and encourages speedy legal closure and resolution at the expense of in-place management and attempts at rehabilitation. Differences with the general corporate bankruptcy code are further widened through an emphasis on formalized early intervention prior to insolvency, quick declaration of insolvency, prompt termination of the bank charter and shareholder control rights, ousting of senior management, strict enforcement of legal priorities of the different creditor classes, potential speed of resolution, lack of creditor standing, limited judicial review, and administrative, rather than judicial, proceedings. The fundamentally different approaches to insolvency resolution of banks and nonbanks derive in part from differences in the goals that these procedures seek to achieve.

The next section reviews the history of bank insolvency laws and procedures as they developed in the U.S. Then, we compare the difference in goals of nonbank corporate bankruptcy and bank insolvency resolution. The following section analyzes differences in a number of the areas enumerated in table 1 between the provisions in the FDI Act for banks and the federal bankruptcy code for general corporations. Next, we consider the issue of multiple jurisdictions that may arise in the failure of large and complex firms. The final section concludes.

History of U.S. bank insolvency regimes

Bank and nonbank insolvency laws and procedures have evolved along different paths in the U.S. Early in our history similar procedures and venues applied to both types of firms, but with the increase of federal involvement in the banking system, the processes diverged.

Article 1, Section 8 of the Constitution of the United States authorizes the federal government to "establish ... uniform laws on the subject of bankruptcies." Nevertheless, Congress was unable to enact a permanent bankruptcy code until 1898. (4) When a permanent federal bankruptcy statute was finally enacted, the act specifically exempted chartered banks. (5) In this period, states dealt with the insolvency of state-chartered banks by suspending or not renewing their charters and appointing a receiver. For the most part, the resolution of insolvent state-chartered banks by states appears to have been conducted similarly to the resolution of nonbanks. …

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