Academic journal article Economic Commentary (Cleveland)

How Well Does Bankruptcy Work When Large Financial Firms Fail? Some Lessons from Lehman Brothers

Academic journal article Economic Commentary (Cleveland)

How Well Does Bankruptcy Work When Large Financial Firms Fail? Some Lessons from Lehman Brothers

Article excerpt

There is disagreement about whether large and complex financial institutions should be allowed to use U.S. bankruptcy law to reorganize when they get into financial difficulty. We look at the Lehman example for lessons about whether bankruptcy law might be a better alternative to bailouts or to resolution under the Dodd-Frank Act's orderly liquidation authority. We find that there is no clear evidence that bankruptcy law is insufficient to handle the resolution of large complex financial firms.

One of the most important questions facing policymakers today is whether the bankruptcy process is, or with modifications could be, a suitable method for handling the failure of complex, nonbank financial firms. Although the DoddFrank Wall Street Reform and Consumer Protection Act of 2009 established an orderly liquidation authority to unwind selected systemically important financial institutions, it left bankruptcy as the default for the rest.

Opinions are sharply divided on the adequacy of U.S. bankruptcy law to resolve complex nonbank financial firms in an orderly fashion. Somewhat ironically, both camps point to the market disruptions that followed the Lehman Brothers bankruptcy filing in 2008 as supporting evidence for their views.

The financial crisis of 2007-2009 was a complex event, so it is not surprising that there are different views about what caused the market turmoil following Lehman's bankruptcy filing. Those views involve differing opinions about whether the bankruptcy resolution of Lehman Brothers was orderly. For example, implicit in the FDICs analysis of the event is the view that the disorderly resolution of Lehman in bankruptcy was a causal factor in the near collapse of financial markets in the fall of 2008. Holders of this view often argue that U.S. bankruptcy law cannot effectively unwind complex nonbank financial institutions, even if the law is amended.

Another view, expressed by many bankruptcy scholars, is that Lehman's reorganization went fairly smoothly and spillover effects were limited. Proponents of this view attribute the market turmoil after Lehman's bankruptcy filing to policy uncertainty: The U.S. government decided to let Lehman fail when the market expected a government-assisted rescue. Still, they acknowledge that the law should be improved to better handle complex financial institutions.

We won't be able to sort this debate out here, but we will point to some lessons that can be drawn from the events surrounding the Lehman bankruptcy filing. These lessons concern whether the insolvency of large or complex financial companies can be adequately handled through the judicial process of bankruptcy. We also consider what changes, if any, need to be made to the bankruptcy code to make bankruptcy a desirable alternative to ad hoc bailouts or to resolution under the Dodd-Frank Act's orderly liquidation authority. In the end, the Lehman case is just one event, and though many people have tried to extract deep meaning from it, the conclusions we can draw from it, though useful, are limited.

U.S. Bankruptcy Law and Complex Financial Institutions

The debate over the ability of U.S. bankruptcy law to resolve complex financial firms largely centers on four questions. Does the bankruptcy of a systemically important firm increase the chances of market turmoil? Will the bankruptcy of such firms cause contagion? Does the law's treatment of qualified financial contracts lead to disorder in bankruptcy resolutions? And finally, do limitations in the scope of bankruptcy law complicate the resolution of complex financial firms? The Lehman bankruptcy grants some insight into each of these questions.

Bankruptcy and Market Turmoil

Lehman Brothers filed for bankruptcy on September 15, 2008. Markets clearly showed signs of increasing stress thereafter and during the fall of 2008. Yields in short-term markets spiked the week following the Lehman filing. …

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