The Economics of Bank Bankruptcy Law

The 2007–2009 financial crisis has shown that bank failures are a common threat in both developed and emerging economies. Hundreds of lenders have failed since the onset of the crisis. One lesson from the recent financial turmoil is the need for more effective systemic regulation. In addition to improvements in the current prudential and regulatory measures that should allow regulators to identify risks at an early stage and prevent them from threatening the entire financial system, there is an increased demand at the national and international level for a specific bank bankruptcy law. This special regime for dealing with troubled banks should create appropriate tools for prompt intervention in the case of bank distress that would allow for efficient reorganization and closure of these institutions in order to limit their impact and protect the safety of the system. Since the onset of the financial crisis, it has become evident that the legal frameworks for resolving troubled banks vary widely across countries. This lack of uniformity between resolution regimes (and, in many instances, the total absence of such regimes) has proved inadequate when dealing with large distressed specialized and/or universal financial institutions, particularly when they had foreign branches and subsidiaries. The immediate consequence has been a disorderly intervention by financial authorities in many countries, which required immense liquidity support for financial institutions and asset guarantees worth several trillion dollars in total.

The primary aim of this book is to understand bank bankruptcy law and to make suggestions on how to improve its design. In order to be able to do this, one first needs to understand the principles behind the general bankruptcy law.

Next, we will analyze what makes banks special, and what this entails for the bankruptcy process involving banks. We review the main characteristics of bank bankruptcy law and describe the methods for restructuring of a failing bank. Subsequently, we show that these characteristics are typically not taken into account in corporate bankruptcy law. Corporate bankruptcy law should therefore be adapted by special amendments, or a completely new bank bankruptcy law could be used.

In order to design the optimal bank restructuring policies, it is important to distinguish between the failure of an individual bank and a bank panic. Theoretical and empirical literature reveals that restructuring policies in a systemic crisis need to be much broader than in the case of an individual bank failure. We first review the theoretical literature on optimal restructuring of banks in a systemic crisis. Second, we survey the empirical literature on systemic crisis. Finally, we evaluate various containment and restructuring methods.

We now explore the main critiques of the general bank regulatory framework and suggest necessary reforms that can address the specific aspects of bank bankruptcy. We first address prudential regulation in banking. Second, we analyze whether systemically important public infrastructure can be separated from the rest of the banking system. Third, we analyze the rationale for netting, and last of all we propose how to contain systemic repercussions caused by the closeout netting provisions of derivative contracts.

We now review the general characteristics of bank bankruptcy laws around the world. Then we focus on selected bank bankruptcy laws in more detail. We analyze characteristics of the Swedish proposal towards the bank insolvency legal framework, the bank bankruptcy regimes in the European Union, Germany, and the U.S., including the provisions of Dodd-Frank Wall Street reform and the consumer protection act, and the recently implemented UK bank bankruptcy regime. Although it is beyond the scope of this study to provide a detailed cross-country legal analysis of bank resolution procedures, our aim is to review, compare, and evaluate the most economically significant characteristics of the selected bank bankruptcy laws.

This chapter first gathers together our proposals for optimal bank bankruptcy law. Subsequently, it reviews several cases of bank failures from the 2007–2009 financial crisis. The cases demonstrate the need for bank bankruptcy law and give the first and admittedly imprecise evidence for the validity of the proposals that we make.

This book explores in detail the principal features of corporate bankruptcy law and subsequently examines the specific characteristics of banks and the functions that they perform in an economy, highlighting the need for a special insolvency regime for financial institutions.

This appendix reviews the design of U.S. corporate bankruptcy law, discusses several critiques, and proposes suggestions of how to reform corporate bankruptcy law.