Shadow Committee posits that bankruptcy law may be better after all

February 23, 2010 — 11:29 PM UTC by Sara Hansard

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Elizabeth’s note: Issues surrounding failures of big financial institutions are important to financial advisors on a number of levels. Never mind the broader economic and investing implications of their actions, mega-banks and their brethren are also the competitors of advisors, the employers of advisors and the source of most breakaways. After all banks now own all the wirehouses. With banks so inextricably tied to the advisory universe, it is important to consider the right course of action when they screw up — which they inevitably do. Sara Hansard has opened a window on this matter with her article. Neither saving AIG’s skin with a government bailout nor letting Lehman Brothers go down the tubes feels right to many people. This article advances our understanding of the issue.

While investment banks or broker-dealers may not like it, large financial institutions should have to go through bankruptcy proceedings like other companies, rather than a resolution system such as the one banks currently fall under, a group of free market academics and an investment advisory firm said Monday.

Invitation-only group

The “Shadow Financial Regulatory Committee,” sponsored by the American Enterprise Institute in Washington, called for subjecting large, complex financial institutions to the current judicial bankruptcy system. The bankruptcy system offers more certainty than a resolution system in which decisions about winners and losers are more arbitrary, according to Robert Eisenbeis, chief monetary economist for Cumberland Advisors, a registered investment advisory firm based in Sarasota, Fla., that manages more than $1.3 billion. Eisenbeis is a member of the Shadow Committee, an invitation-only group of about 8-9 people with expertise in financial services policy issues.

“If you don’t have certainty, you raise the cost of equity; you raise the cost of financing,” said Eisenbeis, who is a former research director at the Federal Reserve Bank of Atlanta.

The committee’s recommendation is timely because federal legislators are trying to pass financial services legislation that would establish a process to cope with a huge, failing financial services institution – like AIG or Lehman Bros., whose differing fates highlight the complexity of the problem.

Bankruptcy law one possible fix

According to Eisenbeis, the committee held a recent briefing with a legislative policy expert who said adapting bankruptcy law to resolve the question of what happens to failing international financial institutions is under consideration. Existing law would need to be adapted, Eisenbeis emphasized, noting, for instance, that there is no international standard of bankruptcy, and that insurance companies and broker-dealers are currently exempt from bankruptcy laws.

A policy built around an adapted bankruptcy law would probably face stiff resistance from the financial services industry, the group acknowledged. “From their standpoint it might not look as good,” as a resolution process, said Stanford Law School professor Kenneth Scott. “The whole point would be to make failures tolerable for that kind of a large institution, so that there would not be the high probability that there is now that there would be a government-funded, taxpayer-funded bailout.”

Providing taxpayer funding to back up large financial institutions as the government has done over the past couple of years reduces risk for people who deal with the financial firms that receive the backing, and it reduces the cost of credit extended to the firm, Scott acknowledged.

But those advantages result in “heads I win, tails the taxpayer loses,” for financial institutions, Scott said. “That’s something that we want to get away from. And would all of the firms involved applaud that? I don’t think necessarily.”

Less exposure for taxpayers

But there is enough flexibility in the bankruptcy statutes that large financial institutions could be dealt with promptly, said Eisenbeis. The fear of long drawn out bankruptcy proceedings has led policy makers in Washington to argue that bank-type resolution authority is necessary to prevent future situations like American International Group Inc., into which the U.S. government has invested more than $180 billion, and Lehman Brothers Inc., which went bankrupt in 2008.

In bankruptcy proceedings, “There is enough flexibility to accommodate the needs of immediacy, and we would have these additional benefits,” such as more predictable terms for creditors and less exposure for taxpayers, Eisenbeis said. “This is one step in the way of breaking that link on too big to fail,” he said.

Mr. Eisenbeis said the issue is important to RIAs because of the way the outcome could affect their clients. Many advisory firms invest their clients’ assets in debt instruments issued by financial service companies, he said.

“If those institutions were to get into financial trouble, they would go into a bank-type resolution process,” he explained. “It’s not always clear in terms of how that process works whose claims are settled, who gets protected. From the investor’s standpoint that raises the cost of holding those financial instruments. It raises the risk.”

Examples of these types of debt instruments include subordinated debt, commercial paper, uninsured deposits, and various kinds of fixed and variable rate investment vehicles, he said. “These companies issue all kinds of debt.”

“The proposals we’re talking about here would give the holders of those instruments standing in a bankruptcy procedure,” he said. “Their claims would be resolved with everybody else.” In the bank resolution administrative procedure, “The people in charge don’t necessarily have to honor those claims.”



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