Making Bankruptcy an Option

For a long time in the United States, we’ve had a way of dealing with failing businesses — the bankruptcy process and bankruptcy courts. It’s a good process, it works well, and it’s served the country well for a long time. It does lead to some firms being liquidated, but many bankrupt firms — just like individuals who need to declare bankruptcy — end up recovering better off than they’d been before. But of course bankruptcy doesn’t work well for all institutions. In particular, conventional bankruptcy has been seen to be inadequate for your standard depositary banks. The fear that a bank will go bankrupt can cause a run on the bank which, in turn, leads it to go bankrupt.

Consequently, we developed a different process for dealing with banks gone bad — FDIC receivership. And even in these times of economic peril and financial crisis, that process seems to be working fine.

At the same time, we’re now suddenly being told that there’s a whole range of other kinds of institutions that don’t fit the FDIC model but for which bankruptcy is also “not an option.” Turns out that all sorts of investment banks and the like can’t be allowed to go bankrupt. And certain kinds of insurance firms like AIG. And also large car companies. And maybe all that is right. But the FDIC model shows us the way we ought to go if there’s some class of entities such that we don’t want to allow the entities to go bankrupt — namely to construct a different process for dealing problems at those firms. You would have some criteria for what kinds of firms count as eligible — not a post hoc “oh, bankruptcy doesn’t work for car companies or investment banks!” proclamation — and a clearly laid-out process for what’s supposed to happen.

Responding on an ad hoc basis to unexpected events is understandable. But a big part of any new regulatory framework needs to be creating a proper framework for cleaning up messes that we don’t think should be cleaned up by the bankruptcy courts. But we’re now months into the current cycle of bailouts, and there’s no sign of public momentum on that front. Meanwhile, doing things in an ad hoc way leaves who gets what more open to the scale of a firm’s political clout (i.e., Citibank > Chrysler > Circuit City) than to any kind of objective assessment of what the economy needs.