Bankruptcy-Proof Finance and the Supply of Liquidity
Goralnik, Nathan, The Yale Law Journal
NOTE CONTENTS INTRODUCTION I. THE DEMAND FOR LIQUIDITY AND THE ROLE OF BANK INSOLVENCY LAW A. Banking as Liquidity Creation B. Implications for Bank Resolution II. THE STRUCTURE OF SHADOW BANKING A. Securitization: Bank Lending Unbundled B. Repos: Shadow Bank "Deposits" III. BANKRUPTCY-PROOFING SHADOW BANKING A. Securitization and Bankruptcy-Remoteness B. The Repo Safe Harbors IV. ASSESSING THE REPO SAFE HARBORS V. SYNTHETIC SECURITIZATION AND THE DERIVATIVE SAFE HARBORS A. Credit-Risk Transfer in Shadow Banking B. Ongoing Challenges C. The Scope of the Rationale for the Derivative Safe Harbors CONCLUSION
The tremors that shook Wall Street in 2008 radiated from a set of novel asset markets straddling the boundary between commercial banking and the capital markets. Mortgage-backed securities and related funding instruments had transformed the credit landscape during the preceding years, enabling institutional investors to supply capital for residential mortgages and other opportunities once accessible only to deposit-taking banks. (1) Thus a "shadow" banking system emerged alongside the regulated banking sector, and grew to rival it in size by its 2007 peak. (2) Only a year later this system collapsed, (3) taking with it many of the country's leading financial institutions and plunging the economy into a deep recession. (4)
Despite the complexity of the transactions involved, the basic dynamics of the 2008 crisis were distressingly familiar. A classic banking panic had occurred, (5) although it struck outside the traditional banking sector and the regulatory institutions protecting it. (6) Banking crises occur when depositors demand more withdrawals than the system's limited cash reserves can satisfy, forcing banks to liquidate assets or seek emergency assistance. (7) Like traditional banks, shadow banks such as Bear Stearns and Lehman Brothers held large portfolios linked to mortgages and other conventional bank receivables. However, these institutions funded themselves using commercial paper and other short-term borrowing markets that lacked the stabilizing influence of FDIC deposit insurance. (8) This left shadow banks vulnerable to a dramatic loss of liquidity as capital fled from mortgage-related assets in 2007 and 2008, (9) forcing officials to rescue entities that lacked access to backstops such as the Federal Reserve's discount window. (10)
Complicating matters, shadow banks faced a paradoxical legal situation as they edged toward the precipice in 2008: although they were regulated as nonbanks, applicable insolvency law treated these institutions rather like traditional banks. As we shall see, this paradox meant that shadow banks were excluded from both the regulatory safeguards available to commercial banks under Title 12 and certain bankruptcy protections available to nonbanks under Title 11.
Banks are not eligible debtors under the Bankruptcy Code, (11) and the Federal Deposit Insurance Act provides neither a general stay nor avoiding powers to protect them from their depositors' claims. (12) In contrast, the Bankruptcy Code gives debtors protection from their creditors' recovery efforts through the automatic stay, (13) avoidance of preferential transfers, (14) and related provisions. (15) Yet unlike most debtors, shadow banks traded heavily in contracts that are exempt from protections ordinarily available to debtors in bankruptcy. (16) These include repurchase agreements (repos), a short-term borrowing instrument that Bear Stearns, for example, used to stay afloat during its final months as an independent company; (17) and derivative contracts, which Wall Street firms used to trade mortgage-related risk. (18) The statutory exemptions for these contracts allow the parties to enforce their contractual rights outside of bankruptcy proceedings. (19) These typically include the right to liquidate collateral from, and to terminate dealings and net mutual obligations with, a distressed counterparty. …