The Economics of Bank Bankruptcy Law

The Economics of Bank Bankruptcy Law

.

Matej Marincˇ • Razvan Vlahu

The Economics

of Bank Bankruptcy Law

Matej Marincˇ

University of Ljubljana

Faculty of Economics

Department for Money and Finance

Kardeljeva pl. 17

1000 Ljubljana

Slovenia

[email protected]

and

Amsterdam Center for Law & Economics (ACLE)

University of Amsterdam

Roeterstraat 11

1018WB Amsterdam

The Netherlands

[email protected]

Razvan Vlahu

De Nederlandsche Bank

Postbus 98

1000 AB Amsterdam

The Netherlands

[email protected]

ISBN 978-3-642-21806-4 e-ISBN 978-3-642-21807-1

DOI 10.1007/978-3-642-21807-1

Springer Heidelberg Dordrecht London New York

Library of Congress Control Number: 2011937430

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Preface

This book shows that a special bank bankruptcy regime is desirable for the efficient

restructuring and/or liquidation of distressed banks. We first explore in detail

the principal features of corporate bankruptcy law. Next, we examine specific char￾acteristics of banks including public confidence, negative externalities of bank

failures, opaqueness and the asset substitution problem, and liquidity provision.

These features distinguish banks from other corporations and are largely neglected

in corporate bankruptcy law. Other implications arise from the pressure of multiple

regulators. Finally, we make recommendations for necessary changes in both

prudential regulation and reorganization policies, which should allow regulators

and banking authorities to better mitigate disruptions in the financial system and

minimize the social costs of bank failures. We support our recommendations with

a discussion of bank failures from the 2007–2009 financial crisis.

Special thanks to Arnoud Boot, Jakob de Haan, Mark Dijkstra, and Timotej Homar. The views

expressed in this book are those of the authors and do not necessarily represent those of the institutions

with which they are affiliated. Vlahu acknowledges financial support from the Gieskes-Strijbis

foundation.

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Contents

1 Introduction .......................................... 1

2 General Issues in Bankruptcy Law ......................... 5

2.1 Coordination Problems . . . ............................ 5

2.2 Ex-Ante Efficiency: Incentives in Bankruptcy Law . . . ........ 8

2.3 Bankruptcy Procedures and Their Ex-Post Efficiency . . . . . . . . . 10

2.4 Corporate Bankruptcy Law: Key Features and Implementation . . 16

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

3 Are Banks Special? Implications for Bank Bankruptcy Law . . . . . 21

3.1 What Is Different About Banks? . . . . . . . . . . . . . . . . . . . . . . . . 21

3.1.1 Liquidity Provision and Bank Runs . . . . . . . . . . . . . . . . 22

3.1.2 Systemic Impact and Regulatory Failure . . . . . . . . . . . . . 23

3.1.3 Ex-Ante Moral Hazard: Risk Shifting . . . . . . . . . . . . . . . 26

3.1.4 Ex-Post Moral Hazard: Opaqueness and Asset

Substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

3.1.5 Multiple Regulators and Political Economy of Banking . . 30

3.2 Bank Bankruptcy Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

3.2.1 Timely Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

3.2.2 Ex-Ante and Ex-Post Optimality . . . . . . . . . . . . . . . . . . 39

3.2.3 Liquidation, Purchase and Assumption Agreement,

and Nationalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

3.2.4 The Design of Bank Bankruptcy Law and Its Relation

to Corporate Bankruptcy Law . . . . . . . . . . . . . . . . . . . . . 49

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

4 Systemic Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

4.1 Theoretical Research on Systemic Crises . . . . . . . . . . . . . . . . . . 65

4.2 Empirical Research on Systemic Crises . . . . . . . . . . . . . . . . . . . 71

4.2.1 Accommodative Approach Towards Resolving

Systemic Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

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4.2.2 Institutional Environment and the Costs

of Systemic Crises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

4.2.3 The Interaction Between Banking Crises, Currency

Crises, and Sovereign Defaults . . . . . . . . . . . . . . . . . . . . 76

4.2.4 Overview of Interventions During the 2007–2009

Financial Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

5 General Issues on the Structure of Banking Industry . . . . . . . . . . . 85

5.1 Strengthening the Ex-Ante Regulatory Framework:

Prudential Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

5.2 Separation of Public Infrastructure from the Financial

System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

5.3 Netting: The Case of Bank Loans . . . . . . . . . . . . . . . . . . . . . . . 91

5.4 Closeout Netting: The Case of Derivative Contracts . . . . . . . . . . 92

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

6 Current Bank Bankruptcy Regimes and Recent Developments . . . 97

6.1 General Overview of Bank Bankruptcy Frameworks

Around the World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

6.2 Early Proposals on the Bank Insolvency Legal Framework:

The Case of Sweden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

6.3 The European Union Bank Bankruptcy and Reorganization

Regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

6.4 The Bank Bankruptcy Regime in Germany . . . . . . . . . . . . . . . . 109

6.5 The U.S. Bank Bankruptcy Regime . . . . . . . . . . . . . . . . . . . . . . 113

6.6 The Dodd-Frank Wall Street Reform and Consumer

Protection Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

6.7 Bank Bankruptcy Regime in the UK . . . . . . . . . . . . . . . . . . . . . 121

6.8 Brief Comparison of U.S., UK, and German Bank

Bankruptcy Law and Assessment . . . . . . . . . . . . . . . . . . . . . . . 124

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

7 Optimal Design of Bank Bankruptcy Law and the Bank Failures

from the 2007–2009 Financial Crisis . . . . . . . . . . . . . . . . . . . . . . . . 133

7.1 Optimal Design of Bank Bankruptcy Law . . . . . . . . . . . . . . . . . 133

7.2 The Northern Rock Collapse . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

7.3 The Lehman Brothers Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . 141

7.4 The Fortis Bank Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

8 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

viii Contents

9 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

9.1 Design of Bankruptcy Law: U.S. Corporate Bankruptcy Law . . . 149

9.1.1 Liquidation Under Chapter 7 Versus Continuation

Under Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

9.1.2 The Evolution of Chapter 11: DIP Financing,

Asset Sales, and Tax Claims . . . . . . . . . . . . . . . . . . . . . 151

9.1.3 Coordination Problems in U.S. Corporate

Bankruptcy Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

9.2 Proposed Reforms of U.S. Corporate Bankruptcy Law . . . . . . . . 153

9.2.1 Shift of Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154

9.2.2 Asset Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

9.3 Summary and Comparison Between U.S. Corporate

and Bank Bankruptcy Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

Contents ix

.

List of Figures

Fig. 4.1 The difference between financial crises with low fiscal costs and

ones with high fiscal costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Fig. 4.2 The difference between financial crises with low output loss

and ones with high output loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Fig. 4.3 The impact of government ownership on the characteristics

of financial crises ...................................................... 75

Fig. 4.4 Intervention policies in the case of (or absence of) currency crisis ... 77

Fig. 4.5 Forms of interventions and government support during the

2007–2009 financial crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

Fig. 4.6 Bank failures and government assistance . . . . . . . . . . . . . . . . . . . . . . . . . . 79

Fig. 4.7 Frequency of various intervention methods in the U.S.

(from January 2001 to November 2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Fig. 4.8 Decomposition of various intervention methods in the U.S. in

terms of asset size of failed banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Fig. 6.1 Frequency of various restructuring methods in 2008 and 2003

(in terms of numbers and assets) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

Fig. 6.2 Restructuring powers of various regulatory bodies (averages;

no ¼ 0, yes ¼ 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Fig. 6.3 The European system of financial supervisors . . . . . . . . . . . . . . . . . . . 107

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List of Tables

Table 2.1 Objectives of corporate bankruptcy law . . . . . . . . . . . . . . . . . . . . . . . . . 15

Table 3.1 What makes banks special? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Table 3.2 How debtor-friendly bank bankruptcy law should

be in comparison to corporate bankruptcy law . . . . . . . . . . . . . . . . . . 43

Table 3.3 Advantages and drawbacks of various modes

of bank resolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Table 3.4 Comparison of the design of bank and corporate

bankruptcy law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Table 3.5 Effectiveness of various attributes of bank bankruptcy law . . . . . 57

Table 4.1 Optimal restructuring in a systemic crisis . . . . . . . . . . . . . . . . . . . . . . . 81

Table 6.1 Characteristics of an average bank bankruptcy framework

around the world (averages across countries,

no ¼ 0, yes ¼ 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

Table 6.2 Comparison of U.S., UK, and German bank

bankruptcy laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

Table 9.1 Comparison of U.S. corporate and bank bankruptcy law

for systematically unimportant banks, and the Dodd￾Frank Act’s provisions for bankruptcy of systematically

important financial institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

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