Europe's Failure to Prepare for the Next Financial Crisis Affects Us All

Article excerpt

2. Shadow Banks

In contrast to the decades-long track record of successful resolutions in the traditional banking sector, governments in both Europe and the United States were largely unprepared for an eruption of similar problems in the nonbank sector. These weaknesses remain unaddressed in Europe, but U.S. policymakers have built a resolution mechanism for systemically significant nonbanks that will likely be able to defuse future systemic threats in the shadow banking system.

a. The United States

As is the case for individuals and most real-economy companies, nonbanks threatened with default on their debt could petition for relief under the Bankruptcy Code. (125) Reorganization or liquidation under the Bankruptcy Code was, and continues to be, the preferred method of dealing with insolvent nonbanks. (126) Under the Code, once a voluntary petition is filed with a bankruptcy court, collection activities of most creditors against nonbanks are automatically stayed until the bankruptcy case is closed or dismissed. (127) While the stay is in effect, the debtor and its creditors work to reorganize or liquidate the firm with varying degrees of cooperation. (128) In this way, the Bankruptcy Code aims to preserve value in struggling firms, increase recoveries for debt holders, and thereby improve the efficiency of credit markets without government intervention or at least without non-judicial government intervention.

Some of these goals may be at odds with financial stability, and the Bankruptcy Code could not stop the transmission of insolvency problems around the shadow banking system in the recent financial crisis. First, some financial transactions critical to shadow banking, such as repo transactions, are exempt from the Bankruptcy Code's automatic stay. (129) This special treatment was introduced when these markets were still in their infancy and resulted in part from a belief among regulators that these markets "were beneficial enough to warrant special treatment." (130) Second, there is no similar guaranteed public funding source for post-petition debtors under the Bankruptcy Code similar to the Deposit Insurance Fund, (131) which helps fund FDIC bank resolution. (132) Nonbanks unable to secure private funding after filing for bankruptcy would be exposed to funding problems, especially with respect to obligations that are exempt from the automatic stay.

These two provisions increased systemic risk in two critical respects. First, by exempting shadow banking market transactions from the bankruptcy automatic stay, participants in the market would have had fewer incentives to monitor the creditworthiness of their counterparties, which could have allowed riskier lending. (133) Second, if a crisis were to occur, repo participants would have been expected to run on their repo counterparties if they feared that their counterparties might become insolvent, similar to the uninsured depositors in bank runs. (134)

The failures of large shadow banks in 2008 demonstrated how contagion may be transmitted by these means throughout the shadow banking system. The Lehman Brothers bankruptcy filing on September 15, 2008, frightened investors and caused investors to run on markets and institutions across the financial system. (135) Some money market mutual funds (MMMFs) had significant exposures to the Lehman bankruptcy, which precipitated a market-wide run in MMMFs. (136) Large MMMF redemptions led to a severe contraction in commercial-paper and repo market liquidity, creating short-term funding problems for other financial firms and many large real-economy companies. (137) Extraordinary measures from the Treasury Department and Federal Reserve prevented a cascade of bankruptcies and a catastrophic financial implosion. (138)

To combat the problems caused by the failure of a systemically significant nonbank, Congress instituted a new nonbank resolution mechanism as part of the Dodd-Frank Act that addresses the contagion transmission problems of the shadow banking system. …


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