Academic journal article Economic Perspectives

Bankruptcy Law and Large Complex Financial Organizations: A Primer

Academic journal article Economic Perspectives

Bankruptcy Law and Large Complex Financial Organizations: A Primer

Article excerpt

Introduction and summary

The avoidance of financial distress has been the subject of voluminous research and protracted debate. This article considers the economic and legal issues surrounding the treatment of firms in financial distress, with a particular focus on the challenges posed by large complex financial organizations (LCFOs).

The successive proposals of the Basel Committee on Banking Supervision (Basel Committee, 2001) to revise bank capital standards, which have preoccupied regulators' and bankers' attentions for several years now, are aimed at ensuring the safety and soundness of banks and indirectly influencing banks' risk taking incentives. Financial institutions have themselves been at the forefront in the quantification and management of risk and have developed a multitude of financial instruments for this purpose, both for their own uses and for the benefit of other sectors of the economy--credit and energy derivatives (1) to name two notable recent innovations. However, while these processes have improved, at least potentially, the management of risk, they do not eliminate the chance of financial distress. From time to time, even in the best of all possible economic worlds, financial firms will fail through unforeseeable economic shocks, mismanagement, or fraud. It is therefore somewhat surprising that this inevitable, tho ugh hopefully rare, eventuality has been so little analyzed by economists. For what happens when a firm fails determines at least in part the arrangements entered into when the firm is solvent and constrains the actions of various interested parties when the firm becomes distressed.

This article provides an overview of the legal treatment of bankruptcy in the U.S. and elsewhere and considers whether the structure and complexity of LCFOs have evolved beyond simplistic corporate structures and contract types historically anticipated in our insolvency legislation and common law traditions. A important part of that evolution has been the development of markets for nontraditional financial instruments used to hedge risk. The involvement of large systemically important institutions in these markets makes it important to consider how these contracts are treated under insolvency and whether this affects the ability of legal and regulatory authorities to resolve these institutions in an orderly and efficient manner.

The failure of an LCFO, of all firms, raises the greatest concern of potential systemic consequences. This is because financial institutions provide capital and other financial services to all sectors of the economy and they form the backbone of the financial markets, markets that rely to a great extent on trust. Thus, the failure of a financial intermediary calls into question a multitude of business relations. In contrast, the failure of a nonfinancial corporation of comparable size is more easily localized: Witness the recent string of bankruptcies of technology firms that have raised no fears of systemic risk in the usual sense of a freezing up of financial markets, in spite of the unprecedented size of the firms involved.

Developed financial markets are generally robust, and the failures of small financial firms, while painful for the creditors, rarely endanger significant numbers of counterparties. This being widely understood, the failure of a small financial institution raises few systemic concerns. (2) However, the failure of a large institution raises concerns that it will directly trigger other failures; for example, by failing to pay its creditors, the insolvent LCFO may cause these other firms to become insolvent. (3) Furthermore, uncertainty in the markets as to who is directly affected by the failure and to what extent may lead participants in the payments system and the short-term capital markets to take defensive measures, thus causing a general contraction of liquidity. This in turn may lead to financial crisis in vulnerable firms that may not even have direct exposure to the firm whose failure triggered the crisis. …

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