Bankruptcy and Resolution
Featured Piece
“A Reassessment of Bankruptcy Reorganization After Chrysler and General Motors ,” by Professor Barry Adler, American Bankruptcy Institute Law Review, Working paper, 2010. ABSTRACT
The descent of Chrysler and General Motors into bankruptcy threatens the Chapter 11 reorganization process itself. In each case, a judge approved a transfer of a debtor’s assets to favored creditors under circumstances where holders of other claims were denied basic safeguards. Legal reform is required, and proposed here, to assure that aggrieved creditors are granted protection either of the marketplace or of the Bankruptcy Code’s creditor democracy provisions. Such reform could help minimize the cost of capital faced by future debtors.
In the Media
“Regulation after the Crash,” by Professors Viral Acharya, Julian Franks, QFinance (www.qfinance.com), May 2009.
Papers
ABSTRACT (Click Here for Paper)
We consider four different approaches to the resolution of distress or failure of large, complex financial institutions (LCFI): (1) laissez-faire or market-based; (2) regulatory forbearance; (3) receivership in hands of government or government-appointed regulator; and, (4) distressed exchanges. We investigate several criteria for evaluating these approaches, including which method works best in liquidity versus fundamental crises, the difficulty with managing failed institutions and the resulting systemic risk, the issue of moral hazard and its impact on future crises, and the impact on taxpayers. While a market-based approach helps resolve insolvent institutions and provides discipline, it may not work well in dealing with systemic risk during a crisis. Regulatory forbearance achieves almost the opposite outcome, simply blunting systemic spillovers during a crisis but at the cost of severe moral hazard. On balance, we find most attractive the receivership approach with temporary transfer of ownership to a resolution authority that provides an orderly restructuring and liquidation (if needed) of the distressed LCFI's. While distressed exchanges also offer a market-based solution that would prevent moral hazard, there remain question marks around their swift implementation for LCFI's and especially their vulnerability to sparking contagious runs on other LCFI's.
We consider four different approaches to the resolution of distress or failure of large, complex financial institutions (LCFI): (1) laissez-faire or market-based; (2) regulatory forbearance; (3) receivership in hands of government or government-appointed regulator; and, (4) distressed exchanges. We investigate several criteria for evaluating these approaches, including which method works best in liquidity versus fundamental crises, the difficulty with managing failed institutions and the resulting systemic risk, the issue of moral hazard and its impact on future crises, and the impact on taxpayers. While a market-based approach helps resolve insolvent institutions and provides discipline, it may not work well in dealing with systemic risk during a crisis. Regulatory forbearance achieves almost the opposite outcome, simply blunting systemic spillovers during a crisis but at the cost of severe moral hazard. On balance, we find most attractive the receivership approach with temporary transfer of ownership to a resolution authority that provides an orderly restructuring and liquidation (if needed) of the distressed LCFI's. While distressed exchanges also offer a market-based solution that would prevent moral hazard, there remain question marks around their swift implementation for LCFI's and especially their vulnerability to sparking contagious runs on other LCFI's.
ABSTRACT (Click Here for Paper)
The descent of Chrysler and General Motors into bankruptcy threatens the Chapter 11 reorganization process itself. In each case, a judge approved a transfer of a debtor's assets to favored creditors under circumstances where holders of other claims were denied basic safeguards. Legal reform is required, and proposed here, to assure that aggrieved creditors are granted protection either of the marketplace or of the Bankruptcy Code's creditor democracy provisions. Such reform could help minimize the cost of capital faced by future debtors.
The descent of Chrysler and General Motors into bankruptcy threatens the Chapter 11 reorganization process itself. In each case, a judge approved a transfer of a debtor's assets to favored creditors under circumstances where holders of other claims were denied basic safeguards. Legal reform is required, and proposed here, to assure that aggrieved creditors are granted protection either of the marketplace or of the Bankruptcy Code's creditor democracy provisions. Such reform could help minimize the cost of capital faced by future debtors.
ABSTRACT (Click Here for Paper)
We argue that when bankruptcy code is creditor-friendly, excessive liquidations cause levered firms to shun innovation, whereas by promoting continuation upon failure, a debtor friendly code induces greater innovation. We provide empirical support for this claim by employing patents as a proxy for innovation. Using time-series changes within a country and cross-country variation in creditor rights, we confirm that a creditor-friendly code leads to lower absolute level of innovation by firms as well as relatively lower innovation by firms in technologically innovative industries. When creditor rights are stronger, technologically innovative industries employ relatively less leverage and grow disproportionately slower.
We argue that when bankruptcy code is creditor-friendly, excessive liquidations cause levered firms to shun innovation, whereas by promoting continuation upon failure, a debtor friendly code induces greater innovation. We provide empirical support for this claim by employing patents as a proxy for innovation. Using time-series changes within a country and cross-country variation in creditor rights, we confirm that a creditor-friendly code leads to lower absolute level of innovation by firms as well as relatively lower innovation by firms in technologically innovative industries. When creditor rights are stronger, technologically innovative industries employ relatively less leverage and grow disproportionately slower.
ABSTRACT (Click Here for Paper)
As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in ‘cash-in-the-market' pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show however that there exists a policy that involves liquidity assistance to surviving banks in the purchase of failed banks and that is equivalent to the bailout policy from an ex-post standpoint. Crucially, the liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and, thereby dominates the bailout policy from an ex-ante standpoint.
As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in ‘cash-in-the-market' pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show however that there exists a policy that involves liquidity assistance to surviving banks in the purchase of failed banks and that is equivalent to the bailout policy from an ex-post standpoint. Crucially, the liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and, thereby dominates the bailout policy from an ex-ante standpoint.
ABSTRACT (Click Here for Paper)
Recently the debate on the reform of the international financial architecture has centered on the development of an appropriate mechanism or regime to ensure orderly sovereign debt restructurings. Recent cases involving sovereign bonded debt restructuring (those of Ecuador, Pakistan, Russia, and Ukraine) have been successfully completed with the use of unilateral debt exchange offers (complemented by a system of carrots and sticks, such as exit consents, to ensure successful deals). But many observers have expressed dissatisfaction with this “market-based” status quo approach. The IMF has proposed the creation of an international debt restructuring mechanism that would have many of the features of an international bankruptcy regime.1 The papers by Jeremy Bulow, Jeffrey Sachs, and Michelle White are all interesting contributions to this debate. All address the question of whether we need an institutional change in the international financial system that would lead to a new way of providing for orderly sovereign debt restructurings or workouts when they become necessary.
Recently the debate on the reform of the international financial architecture has centered on the development of an appropriate mechanism or regime to ensure orderly sovereign debt restructurings. Recent cases involving sovereign bonded debt restructuring (those of Ecuador, Pakistan, Russia, and Ukraine) have been successfully completed with the use of unilateral debt exchange offers (complemented by a system of carrots and sticks, such as exit consents, to ensure successful deals). But many observers have expressed dissatisfaction with this “market-based” status quo approach. The IMF has proposed the creation of an international debt restructuring mechanism that would have many of the features of an international bankruptcy regime.1 The papers by Jeremy Bulow, Jeffrey Sachs, and Michelle White are all interesting contributions to this debate. All address the question of whether we need an institutional change in the international financial system that would lead to a new way of providing for orderly sovereign debt restructurings or workouts when they become necessary.
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