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Financial firm bankruptcy and systemic risk: conventional wisdom overstates the risk of contagion and the chaos of bankruptcy.

Article Excerpt
Systemic risk is the risk that the financial system will fail to function properly because of widespread distress. Failure of the system implies that capital will not be properly allocated and good projects will not be undertaken. Such pervasive financial fragility may occur because one firm's failure causes a cascade of failures throughout the system. Or systemic risk may wreak havoc when a number of financial firms fail simultaneously, as in the Great Depression when more than 9,000 banks failed.

Regulators worry about the next Great Depression and the possibility that financial firm fragility will cause it. Thus they rely heavily on "too big to fail" (TBTF) policies, which they believe stem the impact of one firm's problems on other financial institutions and therefore on the whole economy. TBTF may be justified if the outcome is prevention of a major downswing in the economy. However, if the systemic risks in these episodes have been exaggerated or the salutary effects of the bailout actions have been overestimated, then the cost in efficiency from TBTF policies may far outweigh any potential benefits from attempting to avoid another Great Depression.

No doubt, no regulator wants to take the chance of appearing passive while watching over another depression, so we do not observe empirically what happens to the economy when regulators back off. However, we can analyze how financial crises spread to the real economy and study the related empirical literature. We focus on two types of contagion:

Information contagion: The information that one financial firm is troubled results in negative shocks at other financial institutions largely because the firms share common risk factors

Counterparty contagion: One important financial institution's collapse leads directly to problems at other creditor firms, whose troubles snowball and drive other firms into distress.

The efficacy of TBTF policies depends crucially on which of those two types of systemic risk mechanisms dominates. Counterparty contagion may warrant intervention in individual bank failures, while information contagion likely does not.

If regulators elect not to bail out a failed financial institution, the alternative is to let it go bankrupt. In the case of a failed commercial bank or other depository institution, the process involves the Federal Deposit Insurance Corporation as receiver and the insured liabilities are very quickly repaid. The failure of an investment bank or hedge fund does not involve the FDIC and may closely resemble a Chapter 11 or Chapter 7 filing of a nonfinancial firm. However, if the nonbank financial firm has liabilities that are covered by the Securities Industry Protection Corporation, the firm is required by law under the Securities Industry Protection Act (SIPA) to liquidate under Chapter 7. This explains in large part why only Lehman Brothers' holding company filed for bankruptcy and not its broker-dealer subsidiaries.

A major fear of a financial firm liquidation, whether done through the FDIC or as required by SIPA, is that fire sales will depress recoveries for the creditors of the firm, and the fire sales will have ramifications for other firms in related businesses, even if companies in those businesses do not have direct ties to the failed firm. (See Shleifer and Vishny (1992).) This fear was behind the Fed's decision to extend liquidity to primary dealers in March 2008. As Fed chairman Ben Bernanke explained in a March 13, 2008 speech on financial system stability:

The risk developed that liquidity pressures might force dealers to sell assets into already illiquid markets. This might have resulted in ... [a] fire sale scenario ..., in which a cascade of failures and liquidations sharply depresses asset prices, with adverse financial and economic implications.

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In the same speech, Bernanke cites the concern of a possible fire sale in explaining why the Fed pushed for the hasty merger of Bear Stearns and JP Morgan:

Bear advised the Federal Reserve ... that it would be forced to file for bankruptcy the next day unless alternative sources of funds became available. A bankrupt cy filing would have forced Bear's secured creditors and counterparties to liquidate the underlying collateral and, given the illiquidity of markets, those creditors and counterparties might well have sustained losses. If they responded to losses or the unexpected illiquidity of their holdings by pulling back from providing secured financing to other firms, a much broader liquidity crisis would have ensued....

Bernanke's description of the bankruptcy process highlights the idea that creditors of a failed firm are forced to liquidate assets, and to do so with haste. However, U.S. bankruptcy laws embody the...

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