Academic journal article Economic Commentary (Cleveland)

The History and Rationale for a Separate Bank Resolution Process

Academic journal article Economic Commentary (Cleveland)

The History and Rationale for a Separate Bank Resolution Process

Article excerpt

Everyone recognizes the need to have a credible resolution regime in place for financial companies whose failure could harm the entire financial system, but people disagree about which regime is best. The emergence of the parallel banking system has led policymakers to reconsider the dividing line between firms that should be resolved in bankruptcy and firms that should be subject to a special resolution regime. A look at the history of insolvency resolution in this country suggests that a blended approach is worth considering. Activities that have potential systemic impact might be best handled administratively, while all other claims could be dealt with under a court-supervised resolution.

Lehman Brothers' filing of a petition to reorganize under Chapter 1 1 of the Bankruptcy Code in September 2008 was a watershed event in the recent financial crisis. The ensuing market turmoil led to heated debate about whether bankruptcy is an appropriate mechanism for resolving the insolvency of a systemic financial company. On one side of this debate are those who believe that with some adjustments the judicial process of bankruptcy is a viable option for handling the failures of most types of financial firms. On the other side are proponents of an administrative process akin to that used to resolve insured depository institutions.

In one sense, the Dodd-Frank Consumer Protection and Wall Street Reform Act of 2010 settled this debate. Notable among its reforms is the Orderly Liquidation Authority, a process for resolving systemic nonbank financial companies that parallels a Federal Deposit Insurance Corporation (FDIC) bank receivership. In another sense, Dodd-Frank has fueled further debate: It has made orderly liquidation an exceptional power by mandating that financial companies create and maintain plans for resolution under the Bankruptcy Code; it has also ordered studies of possible reforms to the Code that would allow for more orderly resolution of systemic financial companies through bankruptcy.

Government policy for resolving insolvent financial institutions is at a crossroads. There is little dispute about the importance of designing and implementing a credible resolution regime for systemic financial companies. However, there is considerable debate about the best method for doing so. When deciding between bankruptcy and an FDIC-like administrative process to resolve nonbank financial companies, it is natural to ask why bank failures were ever handled differently. Today, there seems to be general agreement that banks' payments-related functions (from issuing bank notes and taking checkable deposits to clearing and settling payments) require special treatment, but it was not always so. This Commentary seeks to inform the debate by examining how resolution policies for failed banks evolved in U.S. history.

Bank Resolutions in the Pre-Bankruptcy Era

The United States did not enact a permanent federal bankruptcy code until the end of the nineteenth century. Although there had been many attempts to enact such a code, these were either defeated in Congress or, if enacted, were soon repealed. Hence, for much of U.S. history, banking and commerce operated in a world without any federal bankruptcy code. For corporations, including banks, resolution had to take place by other means.

Before enacting the National Currency Act of 1863 and the National Banking Act of 1864 ("the Acts"), the federal government was not in the business of chartering banks (the First and Second Banks of the United States being notable exceptions). Banks were state-chartered corporations, subject to oversight by the state in which they operated; most were designed to selfliquidate when their charters expired, generally after 20 years. However, banks were different from other corporations in one particularly important way: they issued bank notes, which were an important part of the nation's money supply. Deposit-taking was another vital activity of banks during this era, but failure to redeem bank notes was the primary driver of failed-bank resolution policies. …

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